SEC Regulation on Insider Trading: Section 10b

In this article I will discuss one of the most commonly used SEC regulations to prosecute insider trading: Section 10b of 1934 Securities and Exchange Act. There are three major acts passed by the congress to regulate insider trading and to deter illegal insider trading. Securities and Exchange Act of 1934 was passed largely because existing common law was often unsuccessful in dealing with securities abuses by corporate insiders. Securities and Exchange Act of 1934 has several provisions regulating insider trading.

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Section 10(b) of Securities and Exchange Act of 1934 bans trading on material, non-public information, and prohibits any device, scheme, statement, and practice to defraud any person in connection with a security transaction. The first case based on the violation of this rule was brought to courts in 1961, involving Cady, Roberts & Co. In this case, a stockbroker had been informed by a board member about an imminent dividend cut by the company, and the stockbroker sold the shares of the company. The broker was found guilty and this case established a precedent known as disclose or abstain rule. This rule simply states that people who have access to material, nonpublic information should either disclose the information or abstain from trading that security.

Two years after the Cady, Roberts & Co. case, The US Court of Appeals for the 2nd Circuit found in SEC v Texas Gulf Sulphur Co. that “before insiders may act upon material information, such information must have been effectively disclosed in a manner sufficient to insure its availability to the investing public.” This decision clearly supported the “disclose or abstain” rule and provided the broadest formulation of prohibited insider trading.

However, later on in the 1980 case of Chiarella vs. United States, and the 1983 case of Dirks vs. SEC, courts decided that disclose or abstain rule is only applicable when the person has a fiduciary duty to the stockholders. In the case of Vincent Chiarella, who was working in a printing company, Chiarella obtained the names of the tender offer target companies from the documents submitted to him for printing, and made transactions based on that information. In the Dirks vs. SEC case, a financial analyst discovered fraud in a company, and informed Wall Street Journal about the fraud. However, the publication disregarded the information. Consequently, the analyst informed his clients to sell their shares. In these two cases charges against these people were dismissed by the Supreme Court because disclose or abstain rule does not apply to outsiders who do not have a fiduciary duty.

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