Securities and Exchange Commission Historical Society

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

Power of SEC Resilience

Rule 14e-3 and the Misappropriation Theory

Congress's failure to directly prohibit trading on material information about hostile takeovers and to define insider trading based on the misappropriation theory altered the SEC legal strategy. This failure, as well as the SEC's recent defeat in Chiarella, led the SEC to administratively adopt Rule 14e-3. Rule 14e-3 prohibits insiders of the bidder and the target from divulging confidential information about a tender offer, exactly the kind of tippee information the Supreme Court in Chiarella had found not to be a Rule 10b-5 violation. In addition, Rule14e-3, with narrow exceptions, prohibits any person who possesses material information relating to a tender offer by another person from trading in target company securities if the bidder has commenced to taken substantial steps towards commencement of the bid.

Despite Justice Powell's judicial reprimand about expansive rulemaking outside of the common law of fraud, Rule14e-3 is not premised on a breach of a fiduciary duty – the kind of breach that Justice Powell said in Chiarella was required as a prerequisite to SEC enforcement. Rule 14e-3 was the SEC's institutional response to the Chiarella judicial roadblock that had effectively limited the Commission's interpretation of Rule 10b-5.

The dual conundrum that the SEC faced in the 1980s relative to insider trading enforcement was how to respond both to Congressional pressure to "put the boots" to insider traders, and also to legal theories espoused by Justice Powell that threatened its power to enforce insider trading violations that did not resemble common law fraud. The response tested the legal acumen, political skill and administrative resilience of the SEC as it advocated acceptance -- inside the agency and out -- of the misappropriation theory that was espoused by the concurring and dissenting justices in Chiarella as yet another theory of insider trading liability.

The misappropriation theory became the means for the SEC to respond to political pressures from Congress about the abuses from insider trading while avoiding a definition of insider trading that the Commission felt would be used by lawyers to constrict enforcement efforts. Hostile takeovers themselves, argued the SEC, were not the problem, but the abuse of inside information that naturally arose from such takeovers demanded regulation. Ever mindful of its mission to restore public and investor confidence in the markets, the SEC promoted the misappropriation theory as a way to accomplish both goals.

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