Source: https://www.professorbainbridge.com/professorbainbridgecom/2017/08/texas-gulf-sulphur-at-50-the-unworkable-equal-access-to-information-principle.html
Timestamp: 2019-04-24 17:45:44+00:00

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In working on some TGS-related projects, I wrote up some comments on why the TGS equal access test would not have been a workable one. There's nothing here sufficiently new to justify continuing to work it up into a separate law review article, but isn't that what law blogs are for?
Why did the Supreme Court cut the heart out of the TGS? There are a number of serious problems with the equal access test, which would have justified discarding it, such as equal access’ utter lack of support in the legislative history and relevant precedents, but Justice Powell’s main concern was the excessively broad swath equal access cut through legitimate trading activity.
The Supreme Court thus made clear that the disclose or abstain rule is not triggered merely because the trader possesses material nonpublic information. When a 10b-5 action is based upon nondisclosure, there can be no fraud absent a duty to speak, and no such duty arises from the mere possession of nonpublic information. In thereby decisively rejecting equal access, Powell was motivated in large part by concern that such a broad insider trading prohibition would interfere with market efficiency by impeding the work of market analysts and various forms of legitimate trading activity.
TGS was a textbook example of insider trading as the term is usually understood. It involved directors, officers, and managerial executives trading in their own company’s stock (and options thereon) on the basis of material nonpublic inside information. The problem was that TGS contained the seeds of a much broader prohibition.
Second, the prohibition was rapidly extended to include not just inside but also market information. Market information is commonly defined as information about events or developments that affect the market for a company’s securities, but not the company’s assets or earnings. It typically emanates from non-corporate sources and deals primarily with information affecting the trading markets for the corporation’s securities. Inside information typically comes from internal corporate sources and involves events or developments affecting the issuer’s assets or earnings. Within just a few years after TGS, the SEC was aggressively seeking to extend the equal access principle to include the use of material nonpublic market information.
Taken together, these developments eviscerated a potential limiting principle suggested by TGS. The Second Circuit had suggested that liability attached to persons who have “access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone.” If read literally, that passage should have precluded most instances of outsiders trading on market information, but no court ever invoked it to limit the scope of liability.
If taken literally, particularly as expanded in its immediate aftermath, TGS’ equal access could have criminalized much legitimate and, indeed, beneficial market activity. This section identifies some of the more egregious cases.
Since the 1968 passage of the Williams Act, persons who acquire more than 5% of a class of equity securities have been obliged to file a Schedule 13D disclosure statement within 10 days after crossing the 5% threshold. During that 10-day window, it is routine for prospective offerors to acquire as many shares as possible before filing, so that many filers’ initial report discloses holdings considerably in excess of five percent. In doing so, the purchaser is trading on the basis of material non-public market information; namely, the bidder’s plans with respect to a potential acquisition of the target.
First, mergers [and other takeovers] permit the movement of assets from lower- to higher-valued uses through increased efficiencies and redeployment of assets. ... Second, mergers serve as a means to replace or discipline ineffective and entrenched corporate management. Third, mergers can produce efficiencies through joint operating agreements, economies of scale, financial economies and economies of scope. Fourth, mergers can provide resource and service access for both the acquiring and acquired firms.
Trading on the basis of one’s own intentions is an essential element of this beneficial market activity. Having acquired a substantial beachhead in the target’s stock before filing one’s Schedule 13D considerably increases the likelihood of a successful takeover. Yet, the offeror is acting on the basis of a non-erodible information advantage in doing so, which logically should offend the equal access principle.
It is clear, at the outset, that an offeror is not a “market insider” as this term has been defined above. It does not regularly receive nonpublic information concerning any stock but its own. Indeed, with respect to tender offers, it does not receive information but creates it.
But this is clearly not true in all cases. Some acquirers are routinely in the market for corporate control, acquiring companies on a regular basis. In addition, acquirers often receive nonpublic information from financial advisors. The regular access qualification thus failed to ensure that Rule 10b-5 would not impede legitimate trading activity.
In Chiarella, Justice Powell alluded to such concerns by noting that “the broad rule of liability we are asked to adopt in this case” was “in some tension” with the rules governing tender offers. By disavowing equal access, Powell was able to eliminate that tension. The insider trading prohibition thus did not become a de facto takeover defense.
It is commonplace for analysts to “ferret out and analyze information,” and this often is done by meeting with and questioning corporate officers and others who are insiders. And information that the analysts obtain normally may be the basis for judgments as to the market worth of a corporation’s securities. The analyst’s judgment in this respect is made available in market letters or otherwise to clients of the firm. It is the nature of this type of information, and indeed of the markets themselves, that such information cannot be made simultaneously available to all of the corporation’s stockholders or the public generally.
It was in order to avoid chilling such legitimate activity that Powell sought out a policy rationale that would sweep far less broadly.
Here's a hypothetical I often use in class: Francine Farmer owned an 800-acre farm near Blackacre, Texas. In recent months, Farmer has noticed an unusually high number of trucks in the area with out of state license plates. She has also noticed oil drilling rigs on several of her neighbor’s property. So, she was not surprised when an agent of Mammoth Oil Company approached her with an offer to purchase drilling rights on her farm. After eliciting an admission from the agent that Mammoth believed it had discovered a substantial shale oil deposit suitable for fracking, Farmer drove a hard bargain for the drilling rights. Her subsequent review of news sources and Mammoth’s public disclosures led farmer to conclude that Mammoth’s possible oil strike had not become public knowledge. She therefore used the proceeds of her sale to purchase a substantial number of Mammoth shares. When the oil strike was announced, Mammoth’s stock jumped substantially. Farmer sold her shares for a sizeable profit. Shortly thereafter, however, agents of the Securities Exchange Commission (SEC or Commission) arrived at her door and informed her she was under investigation for insider trading in violation of SEC Rule 10b-5.
If the law were still as it was laid out in the seminal Texas Gulf Sulphur (TGS) case, Farmer would face a substantial risk of liability. In that case, the Second Circuit held that the insider trading prohibition applies to “anyone in possession of material inside information,” because Congress intended § 10(b) to assure that “all investors should have equal access to the rewards of participation in securities transactions.” To be sure, as we shall see below, there are a number of ways in which Farmer’s case can be distinguished from the liability creating conduct of the TGS defendants. Yet, even a mildly aggressive reading of TGS plausibly encompasses Farmer’s conduct.
Farmer possesses nonpublic information. If we assume that information is material, and we take literally TGS’s command that “anyone in possession of material inside information must either disclose it to the investing public, or, if he is disabled from disclosing it in order to protect a corporate confidence, or he chooses not to do so, must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed,” Farmer has broken the law.
To be sure, there are a number of important distinctions between the Farmer hypothetical and the facts of TGS. First, the Farmer is an outsider to the company, but this would be unavailing as outsiders can be held liable for engaging in what is somewhat erroneously called insider trading. Second, Farmer is relying at least in part on market rather than the sort of pure inside information at issue in TGS, but it long has been the law that trading while in possession of material nonpublic market information can give rise to Rule 10b-5 liability.
Finally, Farmer might argue that TGS itself limited the scope of liability persons who have “‘access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone.” But the court’s reference to the information being intended for use only for corporate purposes had not prevented the extension of insider trading liability to cases involving market information, which by definition “relates to activities generated by investors, traders, market makers, brokerage firms or others,” and not to information generated by insiders for corporate use. In addition, the Second Circuit in Chiarella extended TGS to apply to “[a]nyone—corporate insider or not—who regularly receives material nonpublic information may not use that information to trade in securities without incurring an affirmative duty to disclose.” The requirement of regular access might well excuse Farmer from liability, but what about market makers, investment analysts, and other corporate outsiders whose very job depends on their having regular access to material nonpublic information?
The regular access limitation also was intended to deal with a recurrent problem in applying the equal access test; namely, its application, if any, to market information one had generated through one’s own efforts. Suppose, for example, that in our hypothetical Farmer had not elicited the admission from Mammoth’s agent. Instead, she based her stock trade solely on the facts she had herself gathered and the logical inferences she drew from them. Would she have had liability?
Getting rid of the equal access test ensured that the Farmers of the world would not be caught up in the insider trading prohibition (although expansive readings of the misappropriation theory might drag them back in, especially if they sign a contract with a confidentiality provision, but that's a story for another day).
* William D. Warren Distinguished Professor of Law. UCLA School of Law.
 SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 848 (2d Cir.), cert. denied, 394 U.S. 976 (1968).
 Chiarella v. United States, 445 U.S. 222, 235 (1980).
 See Stephen M. Bainbridge, Equal Access to Information: The Fraud at the Heart of Texas Gulf Sulphur, __ SMU L. Rev. __ (forthcoming 2018).
 Chiarella v. US, 445 U.S. 222 (1980).
 Dirks v. SEC, 463 U.S. 646 (1983).
 Chiarella, 445 U.S. at 235.
 See A.C. Pritchard, Justice Lewis F. Powell, Jr., and the Counterrevolution in the Federal Securities Laws, 52 Duke L.J. 841, 931 (2003) (“Powell worried that prohibitions against insider trading could chill incentives for analysts and other market professionals to uncover information about publicly traded companies.”); A.C. Pritchard, United States v. O'Hagan: Agency Law and Justice Powell's Legacy for the Law of Insider Trading, 78 B.U. L. Rev. 13, 21 (1998) (“Powell also recognized that imposing a broad-based duty to the market on tippees such as Dirks could have a chilling effect on the process by which information makes its way to the market”).
 See SEC v. Maio, 51 F.3d 623, 631 n.10 (7th Cir. 1995) (noting that “it is a commonplace that the term ‘insider trading’ is a misnomer”).
 Arthur Fleischer, Jr. et al., An Initial Inquiry into the Responsibility to Disclose Market Information, 121 U. Pa. L. Rev. 798, 806 (1973).
 See Roberta S. Karmel, The Relationship Between Mandatory Disclosure and Prohibitions Against Insider Trading: Why A Property Rights Theory of Inside Information Is Untenable, 59 Brook. L. Rev. 149, 154 (1993) (discussing distinction between inside and market information).
 See Fleischer et al., supra note 12, t 801-02 (discussing SEC enforcement efforts relating to market information).
 Id. at 848 (quoting Matter of Cady, Roberts & Co., 40 SEC 907, 912 (1961)).
 See J. Robert Brown, Jr., The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?, 13 J. Corp. L. 683, 692 (1988) (“The high threshold, coupled with the ten-day window, enables incipient bidders to acquire large blocks of stock in advance of an offer ….”).
 See Stephen M. Bainbridge, Precommitment Strategies in Corporate Law: The Case of Dead Hand and No Hand Pills, 29 J. Corp. L. 1, 37 (2003) (“A beachhead acquisition considerably enhances a hostile bidder's chances for success.”).
 United States v. Chiarella, 588 F.2d 1358, 1366 (2d Cir. 1978), rev'd, 445 U.S. 222 (1980).
 See Jay B Kesten, Adjudicating Corporate Auctions, 32 Yale J. on Reg. 45, 67 (2015) (noting that “financial buyers are repeat players in the takeover markets”).
 See Andrew F. Tuch, Banker Loyalty in Mergers and Acquisitions, 94 Tex. L. Rev. 1079, 1096 (2016) (explaining that target financial advisers may “prepare confidential marketing materials for prospective bidders”).
 Chiarella, 445 U.S. at 233-34.
 Id. at 658–59 (citations and footnotes omitted).
 SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir.), cert. denied, 394 U.S. 976 (1968).
 See infra notes TBA and accompanying text.
 Karmel, supra note 13, at 154.
 United States v. Chiarella, 588 F.2d 1358, 1365 (2d Cir. 1978), rev'd, 445 U.S. 222 (1980).

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