Senator James Couzens, Senate Duncan Fletcher and Ferdinand Pecora
(Courtesy of the Library of Congress )
Most states today regulate stock transactions much as they did in the 1930s. While state common law provided the original framework in which the federal rules regarding insider trading operated, after the passage of the Securities Exchange Act of 1934, the SEC entered the debate about insider trading. Yet because the Act did not include a general prohibition or even a definition of insider trading, the SEC did so at first in a way that was both tentative and overly specific.
Instead of a direct frontal attack on insider trading, the SEC promoted the values of full disclosure for investors to insure a high standard of fairness and ethical business dealing in the securities industry. Specific fraud and manipulation prohibitions supported the Exchange Act's disclosure requirements. The core of modern insider trading regulation is Section10(b) of the Exchange Act, which makes it unlawful for "any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails" to use or employ in connection with the purchase or sale of registered or unregistered securities "any manipulative or deceptive device or contrivance" in contravention of the rules and regulations of the SEC.(8) Yet that provision did not specifically define who was an insider or what kinds of transactions were covered by the statute. Thomas Corcoran, one of President Franklin Roosevelt's advisors who spear-headed the lobbying effort in support of the Act, testified that Section 10(b) was intended as a catch-all to prohibit the creation of other devices not covered by more explicit sections of the Exchange Act.(9)
In fact, Congress explicitly addressed insider trading, if at all, only in Section 16(b) of the Exchange Act, which permits the issuer of stock to recover insider short-swing profits, profits earned on purchases and sales that occur within six months of each other. That provision applies only to officers, directors or shareholders who own more than 10 percent of the company's stock, and only if they trade in that company stock. Furthermore, its applicability is limited to firms that must register under the Securities Exchange Act and applies to any equity security. In addition, Section 16(c) prohibits short sales by insiders, an early example of the overall intent of the Exchange Act's regulation prohibiting perceived unfair trading practices.
In a 1965 interview, Ferdinand Pecora recalled how he, Corcoran, James Landis and Benjamin Cohen had drafted Section 16 as "the anti-Wiggin section," named after Albert H. Wiggin, who headed the Chase Manhattan Bank from 1921 to 1933. Pecora recalled how Wiggin had testified that he short-sold Chase National Bank stock that he didn't own but expected to repurchase at a lower price, and thereby took a profit through six different private investment corporations he had established. One of them had taken a profitable position with Sinclair Oil and Refining Company at a time when Sinclair had a large line of credit with Chase Bank. The securities trading abuses of such people, said Pecora, "were the reason that we drafted [Section 16] of the Act, as we burnt the midnight oil."(10)
Over the next five decades, the SEC promoted a securities law regime meant to ensure that all parties to stock market transactions had roughly equal access to material information about the company in which they were trading. To that end, the principal goals of the federal acts were to protect individual investors engaged in stock transactions, and to assure broad public confidence in the integrity of the stock market. Yet the common law of fraud and the soon-to-be-created theories of insider trading would conflict as the SEC developed and administered a regime of securities law meant to promote those goals in a sophisticated and growing national market.
(8) Securities Exchange Act of 1934 (June 6, 1934).
(9) Stock Exchange Regulation, House Hearing, Committee on Interstate and Foreign Commerce, 73rd Congress, 2nd Session (1934), 115.
(10) Robert Bedingfield, "Defining ‘Insider'', The New York Times, April 12, 1965, 63.
