Insider Trading As Fraud

Federal insider-trading law consists, for the most part, of federal common law rooted in a statutory regime that prohibits fraud in connection with the purchase or sale of securities. Commentators have long lamented this fact, viewing the law’s grounding in an anti-fraud statute as a quirk of history with little to recommend it. After all, what does fraud have to do with insider trading? A lot, it turns out. In this article, I develop a theory explaining and defending the fraud-based nature of federal insider trading law. Specifically, I argue that Rule 10b-5, the anti-fraud rule in question, should be understood as altering the common law rule barring parties from contracting for fraud liability. As contract scholars have shown, this common law rule prevents contracting parties from effectively deterring certain hard-to-detect breaches of which insider trading is but one example. Rule 10b-5, I argue, reverses the common law rule, allowing contracting parties to contract for fraud liability and the accompanying extra-compensatory damages for insider trading. The implications of this new theory of insider trading law are significant. First, this theory helps us explain the law as it’s been received, something that competing theories simply can’t do. Second, it implies that insider trading liability under Rule 10b-5 should not be limited to fiduciaries but should include trading by at least some non-fiduciaries as well. Third, this theory provides courts with a tractable way of determining the scope of Rule 10b-5 – they must ask whether the trader and the information source are likely to have contracted for insider trading liability under Rule 10b-5, an inquiry that turns in part on the availability of alternatives to fraud liability for deterring insider trading. Fourth, and finally, the contractual fraud theory of insider trading law implies that, interpreting these implicit contracts over information, the SEC can cast a broader liability net than courts. Consequently, this theory explains not just the Supreme Court’s insider trading jurisprudence but also rules promulgated by the SEC, like rule 10b5-2, which are thought to go beyond the limits of the Court’s interpretation of the statute. This theory implies that the SEC is well within its authority to adopt Rule 10b5-2, a proposition that has been called into question by some federal courts.