Securities and Exchange Commission Historical Society

Fair To All People: The SEC and the Regulation of Insider Trading

Dr. Kurt A Hohenstein, Curator
Opened November 1, 2006

"The 'grass roots folks' are beginning to get wise to the skullduggery going on in the Stock market and we are very glad to see that the Sec Exchange Comm is at long last taking a firm stand against some of the most flagrant items such as the Market ‘riggers' and so called specialists. It is a well known fact that their only purpose is to 'feather' their own nests and those who employ them as they are no doubt in collusion having most of the ‘inside' facts at their command."
- March 15, 1964 letter from Warren S. Loud to the SEC


In March of 1959, when the geologists at the Texas Gulf Sulphur Company (TGS) found evidence of a massive ore deposit near Timmins, Ontario, their excitement was contagious. But they knew that keeping the find secret was essential to the financial success of their discovery. In 1963, when additional testing confirmed a commercially significant discovery of copper and zinc, officials from the company ordered the exploration group to maintain strict confidence so that the company could acquire the rights to mine the surrounding property. Over the next several months, without disclosing the discovery to unsuspecting landowners, company officials purchased the rights to mine this remarkable ore deposit. The company made numerous denials of the discovery in order to permit the company to complete its purchase of the mining rights. Finally, with rumors swirling, TGS announced its discovery in a press conference on April 16, 1964.

During the fall of 1963 and the spring of 1964, while keeping the discovery secret from the public and the landowners, company insiders bought stock and stock options in TGS; others tipped off outsiders who bought TGS stock. Other company officials accepted stock options from TGS without disclosing the discovery to the company's board of directors. Stock prices rose from just under $18 per share in March 1964 to a high of $58 per share when the public first learned the news at the press conference. The insiders, using knowledge of the discovery, had successfully converted that information into a tidy profit.

But the SEC soon took action, filing suit against those insiders for violating Rule 10b-5. Building on a line of reasoning that expanded the application of the common law rules of fraud to include stock trading in an impersonal market, the SEC argued that an insider possessing material nonpublic information must either disclose such information before trading or abstain from trading until the information had been disclosed.

In SEC v. Texas Gulf Sulphur, the Second Circuit Court of Appeals accepted the SEC's argument, despite the fact that under the common law of fraud the company officials had no affirmative duty to disclose the information to the public.(1) The Court agreed with the SEC that Rule 10b-5, the federal prohibition against insider trading that the SEC had used in the case, was intended to assure that "all investors trading on impersonal exchanges have relatively equal access to material information," and that "all members of the investing public should be subject to identical market risks." The ruling in TGS significantly expanded the liability of insiders to include liability to members of the general public who sold stock if the insider who used the inside information breached a duty to the source of the inside information.

Yet the decision created more questions than it answered. Some wondered why it was lawful for insiders possessing that information to hide it from the landowners from whom they purchased the mineral rights, but wrong for possessors of information of the TGS discovery to buy the stock without divulging the information. If the basis for insider trading liability was common law fraud founded in state common law and corporate law principles, could there be liability for insider trading unless the trader had a specific duty to disclose the information to the other party? Could there be such a duty to a person with whom the insider had no common law fiduciary relationship, such as sellers of stock on large, impersonal stock exchanges? How did the Securities Exchange Act, which created the Securities and Exchange Commission, extend the common law and the role of the SEC in regulating corporate securities law? Why should fraudulent transactions in securities law be inherently different from ordinary contract law, thus requiring special regulation by the SEC? What exactly was insider trading and why was it unfair?

It was not the first time that such questions arose about the phenomenon we now know as "insider trading," commonly understood as the purchase or sale by a corporate insider of a corporation's securities while that insider is in possession of material, nonpublic information relating to that corporation. After the passage of the Securities Exchange Act of 1934, the SEC began to think about the enforceability of securities law differently from contract law, where the law of fraud commonly applied. Well-functioning capital markets, the SEC argued, were an essential component of an advanced economy. For policy reasons, securities regulation required more extensive disclosure than that which was required under common law.

Because it was difficult for an investor to know all the information about a company, the SEC interpreted and applied the Securities Exchange Act on the basis that the "undisputed philosophy of securities law was to mandate full disclosure of corporate information" in order to promote a healthy market "fair" to all investors.(2) The history of SEC regulation of insider trading is a story of administrative resiliency, intellectual flexibility, and institutional competence that created the modern system of insider trading enforcement despite the absence of a specific legal definition of the practice.

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(1) 401 F.2d 833 (2nd Circuit, 1968), cert. denied 394 U.S. 976 (1969).

(2) Paula J. Dalley, "From Horse Trading to Insider Trading: The Historical Antecedents of the Insider Trading Debate," 39 William and Mary Law Review 1289 (1998), 1292.

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(left to right) Robert K. McConnaughey, Robert E. Healy, Ganson Purcell, Sumner T. Pike and James J. Caffrey; (lower left, back to camera) Lawrence Greene

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