Recently I had a question that required me to review Don Langevoort’s comprehensive insider trading treatise. It got me thinking about the roots of insider trading law. Specifically, the pre-SEC, pre-10b-5 insider trading courts used to deal with.
Back then, securities were frequently traded in face-to-face transactions, and not on exchanges, certainly not electronic ones. The key insider trading question in those deals was whether the tort of misrepresentation could reach material nondisclosures in addition to affirmative untruths. While some courts were unwilling to find any affirmative duty of disclosure of material facts to trading counterparties (on grounds that corporate officers and directors owe duties only to the corporation itself) others began to overturn the principle of caveat emptor in the corporate context. For instance, in Strong v. Repide, 213 U.S. 419 (1909), a former shareholder of a Philippine sugar company had been induced to sell her shares to a person who (unknown to her) was the company’s general manager. He knew that the company was about to enter into an extremely profitable contract with the Philippine government. The U.S. Supreme Court granted rescission of the sale of securities under what has become known as the “special facts” doctrine. Although recognizing that tort law generally prohibits only affirmative misrepresentations and half-truths, and does not create an affirmative duty to offer all material information to the person on the other side of the transaction, the Court concluded that the special facts of this case – particularly the defendant’s insider position and the significance of the information – were enough to compel disclosure.
This rule was refined and expanded in some later cases to place on all corporate officers and directors a general obligation of affirmative disclosure when dealing with shareholders. Rather than adopting a case-by-case approach, these courts simply announced a blanket rule of compulsory disclosure, derived from the fiduciary status that exists between management and shareholders. Building from this line of precedent, in time it became an established principle of federal law under Rule 10b-5 that insiders owe a fiduciary duty of disclosure when engaged in face-to-face purchases or sales with corporate shareholders.
But who cares? How would this arise today? Consider any number of transactions where a business is broken up into privately held securities and those securities are bought or sold. Suppose X learns a material fact just before the deal is closed. Does X have to disclose the fact to Y? I think Strong v. Repide says the answer is yes, and it’s old-time insider trading if X doesn’t.