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Additional Case: SEC v. Zandford1
Facts: William Wood was an elderly man in poor health whose daughter was mentally disabled. He
placed $419,255 in a brokerage account, instructing his broker, Charles Zandford, that his principal goal
was the “safety of principal and income.” Relying on Zandford’s promise to “conservatively invest” the
money, Wood gave the broker a general power of attorney that permitted him to trade securities in the
account without prior approval. Zandford proceeded to transfer the Woods’ money into his own personal
account. By the time Wood died four years later, all his money was gone. Zandford was convicted of
criminal fraud and sentenced to 52 months in prison.
The SEC filed a civil suit against Zandford alleging that he had violated §10(b). Because of
Zandford’s criminal conviction, the SEC filed a motion asking for summary judgment in the civil case.
Zandford argued that his fraud was not a violation of §10(b) because it was not “connected with the
purchase or sale of a security.” The trial court granted the SEC’s motion for summary judgment but the
Court of Appeals reversed. The Supreme Court granted certiorari.
Issues: What is the scope of §10(b)? What does the term “connected with the purchase or sale of a
security” mean?
Holding: Congress’s goal in passing the 1934 Act was to insure honest securities markets and promote
investor confidence. Congress sought to substitute a philosophy of full disclosure for the philosophy of
caveat emptor and thus to achieve a high standard of business ethics in the securities industry. Zandford
violated §10(b) because this type of fraud prevents investors from trusting their brokers and undermines
the value of discretionary accounts generally.
Question: What did Zandford do wrong?
Question: On what theory does he argue that his crime was not a violation of §10(b)?
Question: Was this a persuasive argument?
Question: What argument did the Supreme Court make?
Answer: The goal of the 1934 Act was to insure honest securities markets and promote investor
General Question: The court also said, “Congress sought to substitute a philosophy of full disclosure
for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the
securities industry.” Is there a “high standard of business ethics in the securities industry”?
Short-Swing Trading—Section 16
Section 16 of the 1934 Act was designed to prevent corporate insiders—officers, directors, and
shareholders who own more than 10 percent of the company—from taking unfair advantage of privileged
information to manipulate the market.
Section 16 takes a two-pronged approach:
First, insiders must report their trades within two business days.
1 122 S.Ct. 1899; 2002 U.S.LEXIS 4023, U.S.Sup.Ct.2002.
Second, insiders must turn over to the corporation any profits they make from the purchase and sale or
sale and purchase of company securities in a six-month period.
Insider Trading
A fiduciary violates Rule 10b-5 (insider trading) if she trades stock of her company while in possession of
non-public material information, unless she has committed in advance to a plan to sell those securities.
Insider trading is a crime punishable by fines and imprisonment, but someone who trades on inside
information is liable only if he breaches a fiduciary duty.
Insiders who pass on non-public, material information are liable under Rule 10b-5, even if they do not
trade themselves, so long as (1) they know the information is confidential and (2) they expect some
personal gain.
Those who receive tips—tippees—are liable for trading on inside information, even if they do not have a
fiduciary relationship to the company, so long as (1) they know the information is confidential, (2) they
know that it came from an insider who was violating his fiduciary duty, and (3) the insider expected some
personal gain.
Case: Securities and Exchange Commission v. Stees2
Facts: Florida East Coast Industries, Inc. (East Coast), was a publicly traded company that operated a
freight railroad between Jacksonville and Miami. As a vice president, Gary Griffiths’s job was to oversee
maintenance of the railcars. He was married to the sister of his high school friend, Rex Steffes. He had
helped Rex’s son Cliff obtain a job driving trains for East Coast.
The CFO of East Coast asked Griffiths to prepare an inventory of all the rolling stock the company
owned and to arrange trips among its rail yards in a special railroad car reserved for visitors. Griffiths also
heard that a large number of men in suits had been touring the company’s rail yards. Yard employees
began asking Griffiths whether East Coast would be sold and whether they would lose their jobs. Indeed,
it turned out that East Coast’s Board of Directors had secretly hired an investment bank to sell the
company.
During this period, Griffiths, Rex and Cliff called each other repeatedly. After the calls, Rex made
various purchases of East Coast stock, although his broker advised against buying so many shares of one
company. Rex ultimately spent a total of $1.14 million on East Coast stock. Also, Cliff purchased the first
call options of his life, spending $15,015 on East Coast.3 After the company was sold, both Rex and Cliff
made substantial profits.
The SEC filed suit, alleging that Griffiths, Rex, and Cliff had violated Section 10(b) and Rule 10b-5.
The men filed a motion to dismiss.
Issue: Did the defendants engage in illegal insider trading?
Decision: Yes, Griffiths, Rex and Cliff were liable for insider trading.
Reasoning: This case is atypical in that Griffiths was not told directly about the merger but instead
figured it out himself. Although no one particular piece of information – such as the fact that men in suits
were touring rail yards – was itself crucial, his ultimate conclusion that a sale was about to take place was
material, nonpublic information.
Although phone calls among family member are not themselves illegal or even suspicious, the
fact that Rex bought stock shortly after each of these calls created a reasonable inference that Griffiths
tipped Rex. The SEC was entitled to prove its case through circumstantial evidence.
2 2011 U.S. Dist. LEXIS 85496.
3 Call options are the right to purchase stock of a company at a specific price for a specific period of
time. A buyer purchases a call option in the expectation that the stock price will go up.
Although Griffiths himself did not buy East Coast stock, he was nonetheless liable, too. He violated
his fiduciary duty by passing on this material nonpublic information. He may not have directly benefited
from the trades but it is well established that the concept of gain is a broad one and includes a gift of
confidential information to a relative or friend.
Question: What information did Griffiths actually possess?
Answer: The SEC alleged that Griffiths possessed material, inside information based on his own
Question: What is the relevance of this decision?
Answer: Some have argued that recent decisions by the SEC have blurred the lines of liability for
Additional Landmark Case: Chiarella v. United States4
Facts: Chiarella was a printer at Pandick Press, a company that printed the documents used to announce
corporate takeover bids. For security reasons, the first drafts of these documents disguised the names of
the companies involved. Chiarella used other information in the early drafts to figure out the identities of
five target companies. He then secretly bought shares in these companies, selling them at a profit once the
takeover was announced and the names revealed.
In the end, however, this scheme did not turn out to be profitable for Chiarella. When the SEC figured out
what he had done, it brought civil charges against him. To settle those charges, he agreed to turn over his
profits to the sellers of the shares. Then Pandick Press fired him, he was convicted of criminal violations
of §10(b) and Rule 10b-5, was sentenced to a year in prison and the Court of Appeals affirmed his
conviction. But the Supreme Court granted certiorari.
Issue: Did Chiarella violate securities laws when he traded on secret information that he acquired in his
job as a printer?
Excerpts from Justice Powell’s Decision: [S]ilence in connection with the purchase or sale of securities
may operate as a fraud actionable under §10(b). But such liability is premised upon a duty to disclose
arising from a relationship of trust and confidence between parties to a transaction. Application of a duty
to disclose prior to trading guarantees that corporate insiders, who have an obligation to place the
shareholder’s welfare before their own, will not benefit personally through fraudulent use of material,
non-public information.
In this case, the defendant was convicted of violating §10(b) although he was not a corporate insider and
he received no confidential information from the target company. Moreover, the “market information”
upon which he relied did not concern the earning power or operations of the target company, but only the
plans of the acquiring company. Defendant’s use of that information was not a fraud under §10(b) unless
he was subject to an affirmative duty to disclose it before trading.
In effect, the trial court instructed the jury that defendant owed a duty to everyone; to all sellers, indeed,
to the market as a whole. The Court of Appeals’ decision rested solely upon its belief that the federal
securities laws have “created a system providing equal access to information necessary for reasoned and
intelligent investment decisions.” The use by anyone of material information not generally available is
4 445 U.S. 222; 1980 U.S. LEXIS 88 SUPREME COURT OF THE UNITED STATES, 1980.
fraudulent, this theory suggests, because such information gives certain buyers or sellers an unfair
advantage over less informed buyers and sellers.
This reasoning suffers from two defects. First, not every instance of financial unfairness constitutes
fraudulent activity under §10(b). Second, the element required to make silence fraudulent -- a duty to
disclose -- is absent in this case. No duty could arise from defendant’s relationship with the sellers of the
target company’s securities, for defendant had no prior dealings with them. He was not their agent, he was
not a fiduciary, he was not a person in whom the sellers had placed their trust and confidence. He was, in
fact, a complete stranger who dealt with the sellers only through impersonal market transactions.
We cannot affirm defendant’s conviction without recognizing a general duty between all participants
in market transactions to forgo actions based on material, non-public information. Formulation of such a
broad duty, should not be undertaken absent some explicit evidence of congressional intent. [N]o such
evidence emerges from the language or legislative history of §10(b). We hold that a duty to disclose under
§10(b) does not arise from the mere possession of non-public market information. The judgment of the
Court of Appeals is Reversed.
Question: What the ruling of the Supreme Court?
Answer: An employee of a printer who handled corporate takeover bids and figured out target
companies’ identities and dealt in their stock without disclosing his knowledge of impending
Question: Did anyone disagree with the majority ruling?
Answer: Yes; in his dissent option, Chief Justice Burger stated that he would have upheld the
Question: Why did the Supreme Court reverse the Court of Appeals holding that Chiarella had
violated §10(b)?
Additional Case: United States v. O’Hagan5
Facts: Grand Met hired the law firm of Dorsey & Whitney to represent it in a takeover of Pillsbury.
James O’Hagan was a partner in Dorsey & Whitney who did not work for Grand Met but who did pur -
chase significant amounts of Pillsbury stock during this period. After Grand Met publicly announced its
takeover attempt, O’Hagan sold his stock at a profit of more than $4.3 million. A jury convicted O’Hagan
of misappropriation in violation of §10(b), and the judge sentenced him to prison. The appeals court
reversed, ruling that misappropriation is not a violation of §10(b). The Supreme Court granted certiorari.
Issue: Is misappropriation a violation of §10(b)?
Holding: Yes, misappropriation is a violation of §10(b). One of the important goals of the Exchange Act
is to ensure honest securities markets and thereby promote investor confidence. It makes no sense to find
5 521 U.S. 642, 117 S. Ct. 2199, 1997 U.S. LEXIS 4033 (United States Supreme Court, 1997).
a lawyer like O’Hagan guilty if he works for a law firm representing the target of a tender offer, but not if
he works for a law firm representing the bidder.
Question: What does §10(b) prohibit?
Question: What does that statute have to do with insider trading?
Question: What is wrong with insider trading?
Question: What did O’Hagan do wrong?
Question: How did he find out this interesting information?
Question: Was there anything wrong with buying Pillsbury stock?
Question: Would it have been clearly illegal to buy Pillsbury stock if O’Hagan’s firm had represented
Pillsbury?
Answer: Yes, that would clearly have been a violation of §10(b) because O’Hagan would have been a
Question: Why is it different for O’Hagan to purchase stock in Pillsbury when he works (indirectly)
for Grand Met?
Answer: As a lawyer for Grand Met, he had no fiduciary duty to Pillsbury, the company whose stock
Question: What did the Supreme Court hold this time?
Answer: It ruled that O’Hagan had misappropriated (i.e., stolen) this securities information from his
Additional Case: United States V. Smith6
Facts: Richard Smith was a vice-president of PDA Engineering, Inc., a software design firm in Califor-
nia. In a one-week period, he sold all 51,445 shares of PDA stock that he owned. He “sold short” an
additional 25,000 shares.7 His parents also sold 12,000 shares. During this period, Smith left the following
voicemail message for a fellow PDA employee:
6 155 F.3d 1051, 1998 U.S. App. LEXIS 20750.
7 Selling short means that he sold stock he did not own, anticipating that the price would go down. When it does go down, he can
make delivery of the stock at the lower price. For example, suppose the stock is selling at $10, and he shorts it. When the stock
goes down to $8, he pays only $8 to deliver stock that he has sold for $10.
I talked to Tom last night after I left you some messages and he and Lou discovered that there was
about a million and a half-dollar mistake in the budget.. ..Anyway, finally I sold all my stock off
on Friday and I’m going to short the stock because I know its going to go down a couple of points
here in the next week as soon as Lou releases the information about next year’s earnings. ..
PDA stock did decline from $8 per share to $5. Smith made a profit of $200,000.
Smith was convicted of insider trading. He appealed, alleging that the jury should have been in-
structed that he was guilty of insider trading only if the government could prove that he had actually used
the insider information. Merely possessing the information was not enough. The Ninth Circuit Court of
Appeals ruled that: “Rule 10b-5 requires that the government (or the SEC, as the case may be) demon-
strate that the suspected insider trader actually used material non-public information in consummating his
transaction.”
This ruling did not help Smith, because the court also ruled that the government had proved that he
did use the inside information. Nonetheless, the SEC viewed the ruling as a blow to its enforcement
efforts.
Question: Richard Smith found out that PDA was going to report disappointing financial informa-
tion. Therefore, he sold all of his stock, shorted even more shares, and suggested his parents do the
same. Is there a problem here?
Question: He claims that he did not use the inside information, that he was trading on general feel,
not specific information. What difference does it make?
Question: Was he home free after this ruling?
Question: Why is the SEC concerned about this case?
General Question: Can you think of an example in which the SEC might not be able to prove that an
insider actually used the inside information he possessed?
Consider the following examples from a newspaper article on insider trading.8 Do your students agree
with the newspaper’s answers?
1. You are a taxi driver who overhears a well-dressed passenger, clearly a corporate bigwig,
ebulliently describe how his employer is about to receive approval for a new blockbuster cure for
cancer. You tell your broker to buy 1,000 shares of the stock.
2. You are the chauffeur for that same executive—he hired you with the understanding that
everything you overhear stays in the car—and he talks of the impending approval.
8 Stephen Labaton and David Leonhardt, “Whispers Inside. Thunder Outside,” New York Times, June 30,
2002, p. C1.
3. Your broker tells you to sell stock in a company because he just received a call from that
company’s chief executive, who instructed him to dump all his holdings. You sell the stock.
4. The same broker advises you to sell but does not say why. He says only that he has a strong belief
that you should do it.
5. A friend tells you that he is depressed because his wife has learned that she will probably be laid
off next week from her job as a top executive. Her company has discovered deep financial
problems, he says, and will disclose them soon. You reassure him, but when he leaves, you call
your broker and execute an order to sell short 5,000 shares of the company’s stock.
6. At your country club, you play golf with a new member who talks about a great new product his
company is about to introduce. He implies that the stock will rise sharply. The next day, you buy
some of the stock.
7. You play golf with that same new member, who talks about the new product but gives no hint that
he is associated with the company or where he received the information. You buy.
8. At a party, you overhear an executive—whom you recognize but do not know—tell another guest
that his company’s outlook has taken a turn for the worse that has not been reported. You call
your broker and sell your interest in that company.
Blue Sky Laws
Currently, all states and the District of Columbia also regulate the sale of securities. These state statutes
are called blue sky laws (because crooks were willing to sell naive investors a “piece of the great blue
sky”).
Antitrust
Congress passed the Sherman Act in 1890 to prevent extreme concentrations of economic power. Because
this statute was aimed at the Standard Oil Trust, which then controlled the oil industry throughout the
country, it was termed antitrust legislation.
Violations of the antitrust laws are divided into two categories: per se and rule of reason. Per se violations
are automatic. Rule of reason violations, on the other hand, are illegal only if they have an
anti-competitive impact on the market.
The Sherman Act
Price-Fixing
Section 1 of the Sherman Act prohibits all agreements “in restraint of trade.” The most common, and
one of the most serious, violations of this provision involves horizontal price-fixing. When competitors
agree on the prices at which they will buy or sell products, their price-fixing is a per se violation of
§1 of the Sherman Act.
