The stock and other securities of large corporations tend to be traded on securities markets. In particular, listed securities such as Apple or IBM stock trade on securities exchanges like the New York Stock Exchange. (These days, exchanges are essentially computer systems matching buy and sell orders received through brokers.) Such trading between investors is also referred to as the secondary market. The primary market denotes sales by the corporation of its own securities to investors—in other words, the primary market is the market where the corporation actually raises capital. By contrast, secondary market trades between investors do not directly impact the finances of the corporation.
Nevertheless, the secondary market is very important for the issuing corporation, and indirectly affects its primary market. Most importantly, the secondary market provides liquidity to its investors, i.e., the ability to turn their investment into cash when desired (by selling to another investor). Investors pay more in the primary market for securities that have a liquid secondary market. In fact, once the secondary market is up and running, the corporation can anonymously sell additional stock directly into the secondary market, or buy it back for that matter (provided it has publicly announced its intention to do this in special SEC filings). Similarly, the liquidity afforded by the secondary market facilitates the acceptance of the corporation’s securities as a means of payment. In particular, public corporations tend to pay their executives mostly in (restricted) stock, and often pay for acquisitions with stock as well (“stock deals”). Illiquid securities without a secondary market are sometimes accepted as payment as well, but less often and only at a discount. Finally, a liquid secondary market supports the accumulation of large minority blocks by activist shareholders without much of a price impact. As a blockholder, the activist will reap a sizeable reward from share price appreciation if the activist’s intervention (engagement with the board, proxy fight, etc.) increases the value of the corporation (see price efficiency below), making the activist’s intervention worthwhile. In this way, liquidity helps overcome the shareholder collective action problem.
Information asymmetry reduces liquidity. The higher the chance that your (anonymous) trading counterparty knows more than you do and trades only because you are getting a bad deal, the less willing you are to trade. To reduce information asymmetry, and to facilitate the exercise of voting and other rights covered in this course, the Exchange Act requires extensive periodic and ad hoc disclosures from issuers of publicly traded securities (see the Securities Law Primer (https://opencasebook.org/casebooks/79342-corporations/resources/1.4-securities-law-primer) in the introductory part of the course).1
Even with ample disclosure, you might worry that you will lose out against a savvy trader who is quicker at collecting or better at processing the information. Fortunately, savvy traders compete with one another for good deals, pushing the security’s price close to the savvy traders’ best estimate of the security’s value. In fact, the efficient capital market hypothesis (ECMH) holds that, in a liquid market, the price will always be exactly equal to the best estimate of the security’s fundamental value given publicly available information. There are two problems with the ECMH, which had its heyday in the 1970s and early 1980s and features prominently in Basic below. First, the ECMH cannot be completely true: if the price were always equal to the best estimate of fundamental value, then nobody could gain from informed trading, and hence nobody would have an incentive to learn and analyze the information required to bring prices in line in the first place. Second, in a world of uncertainty, “fundamental value” is in the eye of the beholder, and savvy traders may just try to predict the misperceptions of others with whom they hope to trade the security tomorrow.2 Much empirical work has shown that the truth is somewhere between that cynical view and the ECMH, and mostly closer to the ECMH: security prices are not completely efficient (i.e., equal to fundamental value), but they are usually a very good approximation. (In either case, most people who think they can outguess everyone else are fools.)
If security prices are a good approximation of fundamental value, it means they summarize information that can be used to evaluate performance. This is the idea behind stock and options as performance pay for executives: the value of their stock and options will track the price of the stock, which is an indicator, albeit a noisy one, of the executives’ performance. By the same logic, price efficiency ensures that an activist shareholder will increase the stock price and hence gain from an intervention only if the activist’s intervention actually improves the corporation. In the case of the executives (but not of the activist!), an important caveat is that even a fully efficient price only reflects public information.3 Top executives can use their discretion under the accounting and disclosure rules to manage the information flow and hence the stock price to increase the value of their performance pay, or simply to avoid being fired. Similarly, corporate insiders (executives, engineers, etc.) can profitably—but not legally, see below—trade their corporation's securities even in fully efficient markets because they frequently possess “material nonpublic information” (mineral discoveries, engineering breakthroughs, regulatory matters, etc.).
Securities trading and securities regulation are thus inextricably intertwined with corporate governance and corporate law. In this course, we cannot cover the details of the disclosure and trading rules under the securities acts. We must, however, spend at least a little time discussing the enforcement of the disclosure rules that we have encountered in this class (e.g., 8-Ks, 10-Ks, 13-Ds, proxy statements, etc.), and more generally of truthfulness of the corporation’s communications to its shareholders. Much of the enforcement burden falls on the SEC, which again belongs in a specialized course. But some of the enforcement is through private securities litigation, often brought by the same law firms that prosecute shareholder actions in Delaware courts. Indeed, these plaintiff law firms used to substitute federal securities lawsuits for Delaware litigation when Delaware courts were less receptive to shareholder lawsuits, and may try to do so again after Trulia. Specifically, we will study private securities fraud litigation under the Securities Exchange Act (SEA) rule 10b-5, which is the most general and hence most important and most controversial basis for such litigation.
The other aspect of securities law we will study is the prohibition and prevention of insider trading. The reason to do so is twofold. First, it is another area that might have fallen under state corporate law if doctrine had developed differently, and to a limited extent still does. Second, insider trading turns out to involve an important corporate governance issue: If insider trading were legal, executives might manage the corporation to maximize trading opportunities rather than corporate value. Besides, insider trading is a crime that most young lawyers will have opportunity and temptation to commit, so it is in your self-interest to learn what not to do. We will study insider trading liability under the SEA rules 10b-5 and 14e-3 and SEA §16(b).
1 Actually, the utility of information by itself does not quite explain why disclosure needs to be mandated by statute, rather than provided voluntarily or, more to the point, under an obligation self-imposed in the corporate charter. We get to these questions in the last part of the course.
2 In the memorable words of John Maynard Keynes’s General Theory of Employment, Interest, and Money (1935):
“professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”
3 Technically, this is known as the semi-strong form of market efficiency. The strong form holds that the price includes all information, even private information. The strong form is quite clearly false, even though some private information does seep into the stock price, in part through legal and illegal insider trading (covered below).
Before delving into the details, let us take a look at rule 10b-5, which is the formal basis of most securities litigation and most insider trading enforcement.
Rule 10b-5 is only one of many anti-fraud rules in securities law (cf., e.g., SEA §14(e) for statements in connection with tender offers). Rule 10b-5 is just the most general, “catch-all” provision—among other things, it applies to any security, not just registered securities. It implements SEA §10(b), which is not self-executing. §10(b) reads in its most relevant substantive part:
“It shall be unlawful for any person . . . [t]o use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe . . .”
Rule 10b-5 was adopted in 1942 without, it appears, much thought or any anticipation of the role it would come to play in the hands of the SEC and the courts later on. SEC staffers wanted to go after an instance of clear common law fraud. To obtain jurisdiction over the case, however, they needed the Commission to adopt a rule under §10(b) first. So the staffers copied §17 of the Securities Act and submitted it to the Commissioners. The Commissioners approved without discussion. See Louis Loss & Joel Seligman, Fundamentals of Securities Regulation 937-8 (4th ed. 2004).
The rule reads:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
a. To employ any device, scheme, or artifice to defraud,
b. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
c. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.
The rule mentions neither a private right of action nor insider trading. But the courts soon implied a private right of action, and the SEC, with approval of the courts, brought insider trading cases under the rule. Ironically, these judicial creations are now recognized in the statute itself. For example, a later amendment of SEA §10 explicitly references “insider trading” rules adopted by the SEC and by judicial precedent, extending such rules to “security-based swap agreements” (i.e., derivatives).
Plaintiffs attempted to bring even more corporate disputes under 10b-5, including cases unrelated to disclosure. In fact, in the early 1970s, most corporate law litigation was brought in the federal district courts under rule 10b-5, rather than in Delaware state courts under state law. Delaware was, at that time, unreceptive to shareholder suits involving fiduciary duty claims. By contrast, the 2nd circuit read rule 10b-5 very expansively. The Supreme Court put an end to this in Santa Fe Industries v. Green(U.S. 1977). In that case, the 2nd circuit had ruled that an unfair cash-out merger could be actionable “fraud” under rule 10b-5 even if defendants had fully disclosed all price-relevant information. The Supreme Court insisted, however, that 10b-5 required “deception, misrepresentation, or nondisclosure.” In general, the Supreme Court has become much more hostile to private securities litigation over time. Thus, you should not expect a judicial expansion beyond what you will read below.
To avoid confusion, it is important to understand that insider trading cases and securities fraud actions involve and emphasize very different aspects of rule 10b-5. Usually, securities fraud cases turn on whether the information was misleading and material, whereas insider trading cases turn on whether the defendant had access to the information and, if so, whether the defendant improperly obtained or traded on it. The main policy question in securities fraud is the availability of the class action (strike suits? Who is deterred if the corporation pays the damages?), whereas the insider trading debate revolves around the definition of inside information and hence the boundaries of legitimate trading. Procedurally, securities fraud is typically litigated in a private class action, while insider trading is typically prosecuted by the S.E.C. or even the U.S. Attorney’s Office. As a result, the legal questions are quite different, even though they formally arise under the same rule 10b-5.