Fairness, Inc.

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Fairness, Inc.The Origins (and Billion-Dollar Bonuses) of

Rule 10b-5 as America’s Insider Trading Prohibition

J. Scott ColesantiProfessor of Legal Writing

Maurice A. Deane School of Law Hofstra University

Carolina Academic PressDurham, North Carolina

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Copyright © 2018J. Scott Colesanti

All Rights Reserved

Library of Congress Cataloging-in-Publication Data

Names: Colesanti, J. Scott, author.Title: Fairness, inc. : the origins (and billion-dollar bonuses) of Rule

10b-5 as America's insider trading prohibition / J. Scott Colesanti.Description: Durham, North Carolina : Carolina Academic Press, LLC, 2018. |

Includes bibliographical references and index.Identifiers: LCCN 2017052810 | ISBN 9781531003746 (alk. paper)Subjects: LCSH: Insider trading in securities--Law and legislation--United

States. | Insider trading in securities--Law and legislation--UnitedStates--History. | United States. Securities and Exchange Commission. Rule10b-5.

Classification: LCC KF1073.I5 C59 2018 | DDC 345.73/0268--dc23LC record available at https://lccn.loc.gov/2017052810

eISBN 978-1-53100-375-3

Carolina Academic Press, LLC700 Kent Street

Durham, North Carolina 27701Telephone (919) 489-7486

Fax (919) 493-5668www.cap-press.com

Printed in the United States of America

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For James and Giovanni, the fairest souls I’ve ever known . . .

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Contents

Preface xiii

Using this Book xix

About the Author xxi

Part One · Victory without Theory

Chapter I · Fairness over Madness: The Congressional Response to the Great Depression 3

A. The People Behind Fairness 3B. The Law of Section 16(b) 9

1. Early Interpretations 9Smolowe v. Delendo 10

2. Other Generous Interpretations 12C. Observations 13

1. Daily Practicalities of 16(b) 142. Perennial Questions 15

Selected Bibliography 17

Chapter II · Fire Trucks and Alarms: The Birth of Rule 10b-5 21A. The People Behind the Rule 21

1. Buybacks without Details 22’33 Act Section 17(a) 23Actual Goals? 24

2. The Result 25B. 1961, and the Birth of Unfair “Insider Trading” 27

Cady, Roberts Determinations 28

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Lasting Effects 30C. The Trappings and the Fallout 31

Fast Forward 32Selected Bibliography 33

Chapter III · “Fairness” Takes Hold: Major Cases and Miner Defendants 35A. The Company and Its People 35B. A Common Claim in Common Law 36

The TGS Bench Trial 37Before the Second Circuit Court of Appeals 39The Lessons of TGS 41

C. The First Derivative Action: Diamond v. Oreamuno 43D. An Aftermath, and a Beginning 45Selected Bibliography 45

Chapter IV (Checkpoint #1) · Elements from the Defense, Defenses in the Elements 47

A. Rule 10b-5’s Initial Scope: Separating Fraud from Disturbances 471. Fraud/Deception (Subdivision “c” within Rule 10b-5)5 482. Materiality (Subdivision “b” of Rule 10b-5) 493. “In Connection With” (Parting Words of Rule 10b-5) 50

As an Element of the Rule 50As a Standing Requirement 51

4. Scienter Requirement (Implied from “Device,” “Scheme,” “Artifice,” and/or “Deceit”) 53

B. Definitional and Procedural Considerations 541. Jurisdiction 562. Presence of a Security 563. Aiding and Abetting Lability 574. Statute of Limitations 57

C. Ubiquitous and Growing 58Selected Bibliography 60

Part Two · The Journey Towards Judicial Empathy

Chapter V · The End of Parity of Information 63A. The People Who Halted the March 63B. Defendants Stand Up, and Congress Takes a Seat 67

1. The First True Setback 67a. The Supreme Court Oral Argument 67

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b. The Resulting Written Decision 692. The Dirks Echo 71

a. The Oral Argument 72b. The Written Decision 74

3. Other Speed Bumps for the Commission 76a. The Insider Trading Sanctions Act 77b. The Insider Trading Securities Fraud Enforcement Act 79

C. Voids and Promises 80Penalties and Consequences 81

Selected Bibliography 83

Chapter VI · The Prohibition’s Period of Uncertainty 85A. The Carpenter Case: The Dangerously Entrepreneurial Reporter 86

The Carpenter Supreme Court Oral Argument 88The Carpenter Written Decision 90

B. The Chestman Case: Excluding Government from Pillow Talk 91C. The Bryan Case: Outright Hostility Towards Legal Rationales 95D. A Half-Dozen Takeaways 97Selected Bibliography 99

Chapter VII · Paradise Regained: The Supreme Court Approves the Misappropriation Theory 101

A. The People Standing in the Crossroads 101B. Vindication at Last— The New (Common) Law 103

1. The O’Hagan Facts 1032. The Supreme Court Case 105

a. The Oral Argument 105b. The Supreme Court Opinion 107Court Silence 108c. The Counterpoints 110

C. The New World Order 1111. The Political Aftermath 1112. The Everyday Practicalities 112

Some Examples 114Selected Bibliography 117

Chapter VIII (Checkpoint #2) · 2001: The Full Arsenal Arrives with the Millennium 119

A. Statutory Sections 1191. Section10(b) 119

CONTENTS ix

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2. Section 16(b) 1203. Section 17(a) 120

B. Rules/Regulations 1211. Rule 10b-5 1212. Regulation FD (“Full Disclosure”) 122

Reg FD Applications 1233. Rule 10b5-1 1254. Rule 10b5-2 (“Duties of Trust or Confidence in

Misappropriation Insider Trading Cases”) 1265. Rule 14e-3 127

C. Chief Cases 1271. United States v. O’Hagan 1272. Dirks v. SEC 1283. Chiarella v. United States 130

D. Tangential Reforms after 2001 1311. The Dodd-Frank Wall Street Reform and Consumer

Protection Act of 2010 1312. The S.T.O.C.K. Act of 2012 131

Conclusion 132Selected Bibliography 132

Part Three · The Players, and Their Tallies

Chapter IX · The Securities and Exchange Commission: The Unparalleled Plaintiff 137

A. The People Who Inspired, Grew, and Contained the Prohibition 137B. Support for SEC Authority, and Its Collection Efforts 141

1. “Fair Funds” 1422. The “Reserve Fund” 143

C. Procedural and Substantive Advantages 145D. Prohibition Substitutes 150

1. Section 13d/Beneficial Ownership Rules 1502. Parallel Provisions, within and outside of the ’34 Act 1503. Order Ticket/Record Keeping/Filing Rules 1514. Identification of Relief Defendants 1515. Charging of “Late Trading” 1516. Charging of “Frontrunning” 1527. The Whistleblower Phenomenon 152

E. Disgorgement and Fines 1531. Disgorgements 154

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2. Fines 155Selected Bibliography 156

Chapter X · Private Attorneys General 159A. Class Actions, Origins and Targets 160B. “Fraud on the Market” and Section 20A on Class Actions 165

Advances in Securities Class Actions 166“Fraud on The Market” and Section 20A 167Payouts 169

C. Other Forces, Great and Small: States, “SROs,” Foreign Lawsuits 170Some Takeaways 172Selected Bibliography 173

Chapter XI · The DOJ: Zealous (But Pointed) Crusader 175A. The People and Guidance behind the Acceleration 176B. Changes to the Law, Direct and Indirect 180

1. The Sentencing Guidelines: At Worst Ignored, at Best, Disparate 181

2. Varying “Scienter” for Purposes of Sections 10(b) and 32 1833. Disrupted Precedent: The Newman Setback to the Prohibition 184

The Salman Case 187The Oral Argument 188The Written Decision in Salman 188

C. The Aftermath of Intense Criminalization 1891. Criminal Investigative Techniques/Independent Investigation

by DOJ 1902. Invitation to Congress 1923. Penalties Unrelated to Wrongdoing 1924. Intensified (Yet Selective) Criminalization 194

Selected Bibliography 196

Chapter XII (Checkpoint #3) · The Evolution of the Insider Trading Fine, and the Final Accounting 199

A. The Dynamic Concepts 199B. Evolution of the Prohibition Fine 200C. Points to Ponder 202

Chapter XIII · Wishing Away the Oasis 203A. The Historical Re-Cap 203B. Not So Rhetorical Hypotheticals 204

CONTENTS xi

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C. Short Term Changes 2081. Clarify the Rule 10b-5 Duty Via Rulemaking 2082. Follow the Statutory DOJ Referral Protocol 2083. Self-Impose Double Jeopardy 2094. Eliminate Differences in Approach between Regional Offices 209

D. Long Term/Doctrinal Modifications 2101. Confine Investigations to the Boardroom 2102. Seek a Statutory Definition of Insider Trading 2113. Learn from Foreign Regulatory Models 2124. Reach More Cases without Rule 10b-5 2125. Strive for SEC Continuity 2136. Educate Public Companies 2147. Deal with High Frequency Trading in Meaningful Fashion 2148. Bring Back the Materiality Analysis 2159. Delegate More Duties to Compliance Personnel 21610. Compel Congress to Let the SEC Self-Fund 216

Selected Bibliography 218

Appendices · Full, Current Versions of Insider Trading Provisions 221Appendix I: Section 16(b) of the Securities Exchange Act of 1934

(“SEA”) 221Appendix II: S.E.C. Rule 10b-5 222Appendix III: S.E.C. Rule 14e-3 223Appendix IV: S.E.C. Regulation FD [added in 2000] 225Appendix V: S.E.C. Rule 10b5-1 229Appendix VI: S.E.C. Rule 10b5-2 231Appendix VII: SEA Section 20A [added in 1988] 232Appendix VIII: SEA Section 21A [added in 1984] 234Appendix IX: SEA Section 21A(g)/S.T.O.C.K. Act of 2012 236

Table of Cases 239

Index 243

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1. Hereinafter “SEC” or “Commission.”

Preface

Boundless Equity

Traditionally, the capitalist world accorded insiders the advantage of usingtheir unique position for personal gain. The story tells of the European deputycommander of the national army being allowed to deposit the entirety of thenation’s defense budget into his personal account (to live off the daily accu-mulating interest). When it came to the personal stock trades of corporatemanagers, the “majority rule” stated that such insiders owed no duty to share-holders to reveal confidential news. Between 1909 and 1933, distinct courts inthe American system began acknowledging rare exceptions between buyers andsellers of corporate stock under the “special circumstances” rule.

The Great Depression (b. 1929) tested this nation’s economic system andway of life like no challenge before. Wall Street was blamed for the majority ofattendant ills. When Franklin Roosevelt took office, a New Deal was usheredin, with an accompanying but unspecific promise of restrictions on access andprivilege. The resulting securities laws, in part, presumed certain stock trans-actions by company insiders to be illegal— under very detailed conditions.

As has been noted countless times, Congress did not then or at any pointthereafter define the violation coined “insider trading.” Nonetheless, the Amer-ican insider trading prohibition (“Prohibition”)— largely encapsulated withinSecurities and Exchange Commission1 Rule 10b-5— has admirably trudgedforward and grown to be the unquestioned worldwide standard. It now coversall parties and all trades. It is readily employed by the SEC, the Departmentof Justice, state regulators, stock exchanges, and private counsel. It is utilizedto garner unfathomable monetary awards as decided by judges and juries; inturn, it cowers defendants to settle accusations, culminating in 2014 with an

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xiv PREFACE

2. Section 16(b) of the Securities Exchange Act, 15 U.S.C. §78p (2012).3. Ralph C. Ferrara, Donna M. Nagy & Herbert Thomas, Ferrara On Insider

Trading and The Wall iii (Law Journal Press 1995).4. United States v. Bryan, 58 F.3d 933, 952–955 (4th Cir. 1995).

epic $1.8 billion fine against a mammoth hedge fund firm. Such cartoonishrecovery raises the question, how did the Rule meant to cabin excesses itselfbecome such a tool for extravagant returns?

—————

I commenced work on my first insider trading investigation in 1989, within6 months of graduating law school. I was shocked by the lack of statutory guid-ance. Further, the legal principles emanated solely from the SEC’s stockpile ofcases from various decades. Within our own regulator, we tried to follow localprecedent and remain true to a list of aggravating factors rumored to existsolely within the market surveillance division (the exact list was never shownto me). “Do what you think is fair, and we can prove,” I recall being told bysuperiors.

Years later, as an adjunct law professor, I focused on the sole hint at a statu-tory standard appearing in a federal securities law: “For the purpose of pre-venting the unfair use of information . . .”2 With those ten words, the 1934Congress loosed generations of varied weapons against what has become a no-torious economic crime.

Decades later, after serving as a securities arbitrator, full-time academic,compliance counsel, public speaker, and author, I can say that my nascent fearsof ill-definition were amply justified. As a cause of action, the whole of Rule10b-5 contains ever-changing parts. When broken into elements, some of themdisappear. In sum, the Prohibition proves most ready to be a hodgepodge re-sponse to any perceived inequity— even when the ad hoc response runs counterto the intentions of its creators. To say that this standard is tied more to eachgeneration’s notion of fairness than to a persisting rule of law is a tragic un-derstatement; the standard wholly varies with the perceived gravity of the fi-nancial privilege in each and every case.

To be sure, the free-form nature of the amorphous regulation has not escapedattention. A highly regarded legal treatise commenced with the sardonic dedi-cation, “For all of those investors who have been protected from a crime thatCongress has been unwilling or unable to define.”3 A Circuit Court said thetheory supporting cases against those outside the subject corporation made usall “pawns in an overall litigation strategy known only to the SEC.”4 The Supreme

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PREFACE xv

Court, which had twice struck down the government’s attempt to render insideinformation contraband, similarly refused the first two attempts to expand theprohibition to non-insiders. Even when ultimately approving the theory bywhich the government charges “outsiders,” the high Court acknowledged thatinformational disparities among investors are inevitable. Still, between 1961and the present, the Prohibition has steadfastly traveled upwards to become thepinnacle business regulation in the history of commerce.

—————

The current Book is the story of a single word, a vague Rule, a few dozenpeople, and a cause memorized by rote. Perhaps the tale is a testament to thepersistence of an agency that itself must sing for its supper from Congress onan annual basis. Indeed, the Commission has steadfastly expanded its insidertrading arsenal, and the worldwide fear of the unique Prohibition arguablyspeaks foremost to the ambitious foresight of a bureaucratic goal.

Or maybe the story hinges on the action of Congress, which, whenrandomly drawn into the scuffle, has consistently empowered an agency andinvestors to seek higher fines through increased litigation.

But more likely, the Prohibition’s raucous journey is a credit to the Amer-ican judiciary, which, ably availing itself of our common law system, hasproven uncannily flexible in bending the equities behind our unique disdainof insider privilege. Boundless Rule 10b-5, the proscription alternativelybranded by the Congress that inspired it “a catchall” and later by the highestCourt “not a catchall,” has more often than not been warmly embraced inthe widest of terms by jurists captivated by an undying quest for marketequality.

And the enforcement of the Prohibition has most often equated wrong withdollars. Indeed, like the Cold War and the Crusades, efforts at combatinginsider trading have quite spectacularly launched careers and generated nearlyincalculable bounties. When it comes to prosecuting insider trading, it appearsthat justice is sometimes blind, but it is always richly rewarded.

While many critiques parse the scant 81 words comprising Rule 10b-5, themore challenging analysis of the humble anti-fraud measure expediently draftednearly 75 years ago may lie in its sole restriction: The claimant party’s abilityto justifiably invoke fairness. From the creation of the modern insider tradingprohibition in 1961 through the present time, the fairness standard remainsthe sole discernible predictor in a body of law perennially racing to keep pacewith the stock market, thus scattering SEC precedent into that infamous rabbithole known as “case-by-case basis.”

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xvi PREFACE

5. In early 2016, a television program titled “Billions” routinely attracted over a millionviewers per episode (and grew to have an open following among lawyers and law students).The fictitious show continues to pit a billionaire hedge fund owner of nefarious meansagainst an overly aggressive federal prosecutor with equally questionable tactics. In oneepisode, a representative of the prosecutor’s office pleaded in vain at a federal court hearingfor the survival of an insider trading Complaint, arguing repeatedly for “fairness to the mar-ketplace.” Billions (Episode 10, “Quality of Life,” original air date of March 27, 2016).

Fairness as contemplated by Congress, the Commission, the experts, or thecourts.

Fairness as a lure to attract foreign investors to the highly regulated Americanmarkets.

Fairness as measuring rod to compensate the victims of greedy villains.

Fairness as a shibboleth, the recitation of which all but ensures a payday forits pronouncer.

Fairness as a Rorschach test with only one interpretation, should we wishthe markets to appear equitable.

Fairness as its own means and end, interpreted on any given day by courts,administrative regulations, private sector guides, government press releases—even in televised docudramas pitting good vs. evil.5 Ultimately, as this justcause grew, fairness towards the insider trader himself has been examined(when he appears to have acted more on serendipity than out of malicious in-tent). Indeed, like second and third generation photocopies of a favoredpicture, the fairness standard is now almost unrecognizable in case results.

Accordingly, this Book traces both the unfathomable growth and the con-sequential earning potential of a rule that transcends its own purpose and lan-guage. Indeed, SEC Rule 10b-5 has become the primary calibrant by whichthe efficacy of regulation is measured, creating estimable careers and fortunesfor its best practitioners. The anti-fraud measure historically whipped up bya coterie of practical regulators in 1942 has swelled to premise fines and dis-gorgements now numbered in the billions. And those billions are shared bygovernment attorneys, prosecutors, the SEC, class action lawyers, nominalplaintiffs, actual victims, educational charities, the Federal budget, and some-times even whistleblowers (both foreign and domestic).

Ideally, the reader will learn both how the Prohibition developed and howit collaterally grew to become a profit center. Regrettably, as the precedentscontinue to multiply, the battle against insider trading has beeninstitutionalized to such a degree that significant reform may not be possible.

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PREFACE xvii

Nevertheless, it is ultimately for the fresh eyes of law students to decide if thefar reach of this storied measure has been judiciously exercised to the benefitof investors, or if it has simply been opportunistically employed in the nameof justice.

The Chinese proverb says, “The best way to predict the future is to inventit.” No one could have predicted the various means by which regulatory andprivate fortunes have been generated by a weapon called fairness, but Rule 10b-5 most certainly invented them. The fairness standard is either a healthy sub-ordination of law to a worthy Congressional goal or the ledger by which anunnamed but juggernaut corporation generates bonuses for all of its managers.Concomitantly, Rule 10b-5’s exponential growth is alternatively a triumph ofreason over formality or a cautionary tale of scapegoat profiteering. Either way,when it comes to insider trading, the Rule has essentially functioned as a cor-poration, garnering billions from (and for) those in its path.

J. Scott Colesanti, LL.M.February 2018

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Using This Book

This Book has a two-fold purpose: 1) Describing in detail the origins ofAmerican insider trading law, primarily effectuated through application of Se-curities and Exchange Commission Rule 10b-5, and 2) Detailing the reasonsfor the revenue streams therefrom. The Book’s three parts deal with, in turn,the history of the Prohibition, its period of greatest challenge, and its current(and cowering) embodiment. In turn, each Chapter strives to meets its goalthrough 3–5 sections progressing from the people to the law to the result. Afterevery three Chapters, a “Checkpoint” Chapter revisits the lessons of the pre-ceding part while gauging the Prohibition’s growth.

Footnotes in each Chapter provide direction to the source of a quote or newassertion. For broader reference, a selected bibliography concludes eachChapter; this listing attempts to both further corroborate the statements ineach Chapter and to present a variety of views on the key cases and events dis-cussed therein.

It is impossible to research this field without being struck by the sheer rep-etition of the term “fairness” by attorneys, policy makers, victims, legislators,and jurists. Accordingly, throughout the Book, the term is highlighted in bold.

Because the role of the lawyer is to offer solutions, the Book concludes withover a dozen short and long-term suggestions for a variation on the status quo.

The accompanying Teacher’s Manual offers some additional timely questionsand cases, as well as more food for thought.

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About the Author

J. Scott Colesanti, LL.M., was the first law clerk to a Chief Hearing Officerof the New York Stock Exchange. He investigated his initial insider tradingcases within a year of his law school graduation and subsequently served as theyoungest Trial Counsel for the New York Stock Exchange Division of Enforce-ment during his 10-year tenure.

Professor Colesanti has taught at the law school level for over 17 years. In2006, while serving as an adjunct, he was selected “Professor of the Year” bythe Hofstra Law Review. He has developed and taught 10 courses and has hadover 20 articles published by legal journals. His writings are included in treatiseson securities law and as expert commentaries to seminal cases.

He has also served within the NYSE Office of the General Counsel, and as asecurities industry arbitrator for over a decade. Professor Colesanti has handledappeals before the Securities and Exchange Commission, the Social SecurityAdministration, the EEOC, and the New York State Division of Human Rights.

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xxii ABOUT THE AUTHOR

Professor Colesanti regularly lectures on the Financial Crisis and has lec-tured/ taught abroad on securities fraud and insider trading. He served on theeditorial board of the Journal of Securities Law, Regulation and Compliance, andis a former contributing co-editor of the Business Law Professor Blog. As of Au-gust 2017, Professor Colesanti was rated among the top 10% of authors rankedby downloads on the Social Science Research Network. “Fairness, Inc.” is histhird released book.

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