The Myriad Ways SEC Rule 10b5-1 Is Invalid

The Securities and Exchange Commission (SEC) adopted Rule 10b5-1 to define an element of insider trading in violation of Rule 10b-5. Rule 10b5-1 provides that Rule 10b-5 is violated by purchasing or selling a security of any issuer 'on the basis of' material nonpublic information about that security or issuer, which means 'the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale.' The rule also adopted exclusive defenses a purchaser or seller can use to demonstrate that he did not use material nonpublic information in trading and thus did not violate Rule 10b-5. Critical aspects of Rule 10b5-1 are invalid. 1) Rule 10b5-1 exceeds the SEC's rulemaking powers under section 10(b) because a 10(b)-based rule cannot impose liability unless the rule prohibits the use or employment of material nonpublic information. 2) The definition of 'on the basis of' in Rule 10b5-1(b) disregards controlling caselaw in at least one significant respect, departing from the SEC's own understanding of the phrase. In particular, the courts have determined that in a misappropriation case, 'use' of material nonpublic information, not mere awareness of that information, is an essential element of the claim. For this and other reasons, the SEC's adoption of the definition was arbitrary and capricious. 3) The SEC exceeded its authority in adopting exclusive affirmative defenses to a charge of violating Rule 10b-5 that preclude an alleged violator from asserting other grounds to demonstrate that he did not use the material nonpublic information in trading. 4) Rule 10b5-1 fails to make any distinction between claims based on the classical theory or based on the misappropriation theory and between civil enforcement and criminal claims. Contents I. Introduction 25 A. The Law of Insider Trading in Summary 25 B. The Issues Addressed in This Article 27 II. The Possession Versus Use Debate 28 A. The Common Law on Possession Versus Use 29 B. The Federal Law of Possession Versus Use 29 1. Rulings and Statements by the Commission and Its Staff 30 2. Insider Trading Opinions of the Supreme Court 32 3. Salient Rulings in the Lower Courts 33 4. Commentary After the Judicial Triad 36 5. Legislation in the 1980s 37 III. The Adoption and Amendment of Rule 10b5-1 41 A. The Adoption of Rule 10b5-1 41 1. The Provisions of Rule 10b5-1 41 2. The Unexplained Disappearance of the Possession Test 42 3. The Uncertain Meaning of 'Aware' 42 4. The Weakness of the Inevitably Argument 43 B. In the End, What Matters Is Use or Non-use, Especially in Misappropriation Cases 43 C. The 2022 Amendments of Rule 10b5-1 44 IV. Possession Versus Use After Rule 10b5-1 45 V. The Definitional Provisions in Rule 10b5-1 Exceed the Congressional Grant of Power to the SEC in Section 10(b) 47 A. The Scope of Section 10(b) and Rules Thereunder 47 B. Application of Principles of Administrative Law 49 VI. The Rule 10b5-1 Definition of 'on the Basis of' Is Arbitrary and Capricious and Thus Invalid 50 A. The Ordinary Meaning of Acting 'on the Basis of' Is Acting Deliberately 50 B. The Commission Had Recognized that the Phrase 'on the Basis of' MNPI Meant to Use it 51 C. The Commission's Adoption of the Opposite of What the Courts and the Commission Itself Said 'on the Basis of' Means Was Arbitrary and Capricious 52 VII. Rule 10b5-1 Improperly Adopted 'Exclusive' Defenses 58 VIII. Can Rule 10b5-1 Be Salvaged? 61 IX. Conclusion 62 The otherwise laudable efforts of the Securities and Exchange Commission (SEC or Commission) to rein in trading on the basis of material nonpublic information (MNPI) have been accompanied by an administrative overreach when the SEC adopted a rule that seeks to define an essential element of unlawful insider trading. This Article does not argue that the rule should have been drafted differently as a matter of judgment among permissible alternatives, as many who commented on the proposed rule argued. Rather, this Article addresses the heart of the rule, demonstrating fundamental legal shortcomings. (1) The flawed aspects of the rule should not be countenanced--they are not enforceable.
I. INTRODUCTION A. THE LAW OF INSIDER TRADING IN SUMMARY A substantial body of federal common law delineates when it is unlawful to trade securities based on MNPI. (2) This [...]