Rule 10b-5 and the Rise of the Unjust Enrichment Principle

James J. Park - Brooklyn Law School

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Securities regulation has traditionally focused on encouraging truthful disclosure that facilitates the accurate pricing of securities. A typical securities fraud claim under the primary antifraud rule, Rule 10b-5,1 must thus point to a misrepresentation or omission that is material to investors. As Justice Lewis Powell declared in an often-quoted passage from Chiarella v. United States,2 “Section 10(b) is aptly described as a catchall provision, but what it catches must be fraud.”3 At the same time, Rule 10b-5 has been extended to conduct that does not fit the traditional conception of fraud—most notably, insider trading.

My Article shows that such deviations have become more common as Rule 10b-5 has become increasingly concerned with the problem of unjust enrichment.4 In numerous areas, courts have applied Rule 10b-5 to deceptive conduct that is not directed at the market or investors, but that unjustly enriches some individual. Surprisingly, the unjust enrichment principle has functioned not only as an expander of liability, but also as a limit. More and more, securities fraud class actions directed at market-distorting misrepresentations may proceed only if insiders have been enriched by the misrepresentation. Rule 10b-5 is becoming as much an unjust enrichment prohibition as it has been a fraud prohibition.

The rise of the unjust enrichment principle demonstrates that securities regulation is not solely concerned with the economic value of market efficiency, but also is significantly influenced by public values. Securities regulation is guided by an evolving principle that somewhat limits the ability to extract wrongful gains from the securities markets. Although unjust enrichment is a concern of Rule 10b-5, it should be a second-order concern subordinate to the first-order concern of efficient markets.


I.
Rule 10b-5 as an Antifraud Rule

In its early days, the primary goal of securities regulation was protecting investors. Though investor protection still plays a significant role in securities regulation, the focus of protection has shifted from the investor to the market. These developments partly resulted from the incorporation of financial theory into both the legal literature and legal doctrine.

Beginning in the 1960s, financial economists hypothesized that stock markets were efficient in that a stock price reflects all known information relevant to the value of the stock.5 The efficient-markets hypothesis became a leading theoretical justification for securities regulation. By 1968, economist Irwin Friend could declare: “The economic justification for disclosure, which is perhaps the most basic mechanism of securities regulation, is the belief that the provision of information to prospective investors is a necessary condition for efficient markets.”6 Professor Victor Brudney similarly noted in 1979 that the goal of an antifraud provision “is to improve the efficiency of the market so that price reflects value, and therefore financial, and ultimately real, resources will be optimally allocated.”7

Consistent with the view that Rule 10b-5 primarily encourages efficient markets, courts, for a time, mostly interpreted Rule 10b-5 as a narrow antifraud rule. This antifraud conception is defined by at least three essential elements: First, there must be a misrepresentation or omission. In Santa Fe Industries v. Green,8 the Supreme Court found that a breach of fiduciary duty could not be the basis of a Rule 10b-5 claim without some “deception, misrepresentation, or nondisclosure.”9 Second, the misrepresentation or omission must be material—that is, “disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.”10 Third, the material misrepresentation or omission must be “in connection” with a securities transaction.11


II.
Rule 10b-5, Insider Trading, and the Unjust Enrichment Principle

Despite the theoretical and doctrinal power of portraying Rule 10b-5 as an antifraud rule that promotes efficient markets, one area of Rule 10b-5 jurisprudence is difficult to reconcile with that narrative: the rule’s prohibition of insider trading fits uneasily with the view that Rule 10b-5 is directed primarily at fraud.

The quintessential example of insider trading involves an individual who has obtained important information about a public company that is not available to the public. When that information becomes publicly known, the company’s stock price will move significantly higher (or lower). The trader can profit from such information by purchasing (or selling) the stock before the information is released. Rule 10b-5 has been the primary basis for prohibiting insider trading, but it is difficult to say that an individual investor can defraud the market by simply purchasing or selling stock in the open market.

Rather than basing liability on an affirmative misrepresentation, the classical theory of insider trading bases the prohibition on a fraudulent failure to disclose. Fraud liability for nondisclosure can only attach when there is a duty to make a disclosure. Such a duty exists with respect to directors and officers of a corporation, whom, as fiduciaries of the shareholders, cannot profit at the expense of shareholders without disclosure. Rule 10b-5 has thus been read to subject such insiders to what has been called the “disclose or abstain” rule.

The disclose or abstain rule allows for a substantial amount of trading on nonpublic information. If an individual is not a fiduciary, there is no fiduciary duty to disclose. In the classic case, Chiarella v. United States,12 the Supreme Court overturned the criminal conviction of a noninsider, Chiarella, because he was not an officer or director of any of the companies whose stock he traded, and thus he owed no duty of disclosure to the shareholders of those companies.13

Despite its focus on fiduciary duty, Chiarella also laid the foundation for an unjust enrichment rationale for prohibiting insider trading. In his dissent, Chief Justice Warren Burger argued that Chiarella’s conduct should trigger liability because it “quite clearly serves no useful function except his own enrichment at the expense of others.”14 Burger thus urged the Court to adopt a misappropriation theory that would cover noninsiders.

In United States v. O’Hagan,15 the Supreme Court extended the insider trading prohibition beyond fiduciary relationships to misappropriators without a fiduciary duty to the traded company’s shareholders. O’Hagan was an attorney for a firm that represented an acquirer of another company. Although O’Hagan and his firm owed a duty to the acquirer, O’Hagan owed no fiduciary duty to the target company. Affirming O’Hagan’s conviction for insider trading, the Court adopted what it called the “misappropriation theory,”16 which was “designed to ‘protec[t] the integrity of the securities markets against abuses by outsiders.’”17

Under the misappropriation theory, a noninsider is liable for insider trading if he misappropriates information from a source to which he owes some duty of confidentiality. Rather than “premising liability on a fiduciary relationship between company insider and purchaser or seller of the company’s stock, the misappropriation theory premises liability on a fiduciary-turned-trader’s deception of those who entrusted him with access to confidential information.”18 O’Hagan violated this rule because he deceived the source of the information, his law firm, to which he owed a duty of confidentiality.

By broadening Rule 10b-5 to encompass agency relationships other than the fiduciary relationship between insiders and shareholders, the misappropriation theory runs further from the antifraud and efficient-markets conception of Rule 10b-5, and closer to the unjust enrichment principle. Although the classical theory of insider trading grounds liability in the breach of a duty to disclose owed to shareholders, the duty at stake in O’Hagan was a duty to a law firm. A law firm is not a direct market participant and cannot be said to be the market. In contrast to the typical fraud-on-the-market case where there is a direct link between a deception and the market, a misappropriation insider trading case involves conduct that is at best tenuously linked to the market.

After O’Hagan, the contours of a substantive unjust enrichment principle rooted in Rule 10b-5 have begun to emerge: First, rather than requiring a specific misrepresentation or omission directed at the market or investors, the unjust enrichment principle covers broader forms of deceptive conduct, such as misappropriation, that are not necessarily directed at the market or investors. Second, the unjust enrichment principle is not limited to conduct that directly harms the market, but also covers conduct with a more tenuous connection to a securities transaction. Third, the unjust enrichment principle focuses primarily on benefits wrongfully extracted by the defendant at the expense of others.

Subsequent to O’Hagan, the unjust enrichment principle has expanded the reach of Rule 10b-5 in a number of areas:19 the Rule 10b-5 materiality standard governing financial misstatements has been expanded to include financial misstatements meant to enrich an individual; Rule 10b-5 has been interpreted to cover broker-dealer misappropriation that does not involve an affirmative misrepresentation to the market or investors; and Rule 10b-5 has been applied both to mutual-fund market timing through which mutual fund managers enriched themselves at the expense of their investors, and to stock option backdating where individuals manipulated stock options to enrich themselves.


III.
The Convergence of Unjust Enrichment and Fraud

Though the unjust enrichment strand of Rule 10b-5 doctrine is distinct from the rule’s antifraud roots, the unjust enrichment and fraud conceptions of Rule 10b-5 have curiously converged. By affecting the pleading requirements that a plaintiff must meet to move past the motion-to-dismiss stage in a securities-fraud class action, the unjust enrichment principle has been subtly used as a way of shaping how Rule 10b-5 targets fraud . In many cases, it is becoming more difficult for plaintiffs to avoid dismissal without alleging that some manager was unjustly enriched through the fraud.

Using the unjust enrichment principle as a limit originates from the scienter requirement of a Rule 10b-5 securities fraud action. In Ernst & Ernst v. Hochfelder,20 the Supreme Court sensibly read the text of Section 10(b) of the Securities Exchange Act as not extending liability to negligent acts. The Court held that to establish securities fraud under Rule 10b-5, a defendant must have acted with some degree of deceptive intent—that is, with scienter.21 In addition, the Private Securities Litigation Reform Act of 1995 (PSLRA)22 adopted a heightened pleading test with respect to scienter in order to reduce the incidence of abusive securities fraud class actions. The PSLRA requires that the plaintiff plead facts establishing a “strong inference” of fraudulent intent.23

Many courts now focus on the existence of unjust enrichment in determining whether the PSLRA’s heightened pleading standard has been met. For example, the Second Circuit has held that only allegations of personal or “concrete benefits” will suffice to establish the requisite motive for a finding of scienter.24 The Ninth Circuit has stated that allegations of insider trading are relevant in supporting allegations of scienter.25 And the Supreme Court has acknowledged that although motive is not a prerequisite to liability, “personal financial gain may weigh heavily in favor of a scienter inference.”26

A few commentators have gone even further and argued that securities fraud class actions under Rule 10b-5 should be limited to cases against individuals who are unjustly enriched by misrepresentations to the market.27 These scholars contend that because the benefits of Rule 10b-5 class actions may be outweighed by the costs, the reach of Rule 10b-5 should be limited to combating misrepresentations that are meant to enable insider trading. If implemented, such a limit would complete the transformation of Rule 10b-5 from a fraud to an unjust-enrichment prohibition.


IV.
Reconciling Efficient Markets and Unjust Enrichment

Ironically, the once-controversial use of Rule 10b-5 to prohibit insider trading is now rarely questioned, whereas the conventional use of Rule 10b-5 to deter deceptive misstatements that distort stock market prices is increasingly limited to cases involving insider enrichment. My Article seeks to reconcile the unjust enrichment principle with the traditional efficient-markets conception by thinking of Rule 10b-5 as having first-order and second-order concerns. The first-order concern reflects the traditional economic goal of encouraging efficient markets. The second order reflects a concern with unjust enrichment that offends public values.


A.     Efficient Markets

Despite the increasing legitimacy of the unjust enrichment principle, courts and policymakers should be cautious in thinking of Rule 10b-5 as mainly targeting unjust enrichment. The first-order concern of Rule 10b-5 is to encourage companies to disclose accurate information, thereby enabling markets to function efficiently.

The convenience of narrowing the scienter standard comes at a cost—a growing disconnect between the screening standard and the role of securities fraud class actions as a facilitator of efficient markets. Perhaps the greatest danger posed by the rise of the unjust enrichment principle may not be its actual effect on the ability of securities fraud class actions to deter, but its tendency to shift focus from the first-order concern of efficient markets to what is essentially a second-order concern. To the extent that securities fraud class actions turn on whether there is proof of individual enrichment, results will seem arbitrary. Suppose Company A commits the same accounting misstatement as Company B. Managers of both companies are motivated by a desire to increase the stock price, but only Company B is liable because an executive happened to sell a significant amount of stock. If the primary concern is to promote efficient markets, the relevant consideration should be the intent to deceive the market rather than personal enrichment.

Courts might strike a better balance between screening meritless cases and maintaining a regime in which Rule 10b-5 consistently encourages efficient markets by not defining scienter exclusively in terms of concrete benefits. Fraud that is motivated by a general desire to make the corporation appear to be doing better than it is can be just as harmful to the market as fraud that is motivated by a desire to personally benefit through stock sales.

The increasing focus of securities law on scienter, which mainly assesses a defendant’s unjust enrichment, rather than on materiality, which assesses the potential harm of the misstatement to the market, is perhaps the strongest evidence that Rule 10b-5 is becoming an unjust enrichment rule. Reversing this trend may require revival of the materiality standard. The materiality standard may be a better way of managing the administrative costs of Rule 10b-5 in a way that does not conflict with the first-order concern of encouraging efficient markets.28 Further, it would orient courts toward asking the question that matters—does the misstatement affect the ability of the markets to value a stock?—rather than the secondary question of whether the misstatement was made to enrich an insider.


B.     The Unjust Enrichment Principle

Although the efficient-markets purpose of Rule 10b-5 is important, the rule is also concerned with enforcing the unjust enrichment principle. The best way to reconcile the unjust enrichment principle with the conception of Rule 10b-5 as an antifraud rule is to think of unjust enrichment as a distinct but second-order concern. The rise of the unjust enrichment principle reflects the reality that securities regulation is not solely concerned with efficiency considerations, but also with widely recognized public values. At its core, the unjust enrichment principle applied to the securities regulation context sets limits on the extraction of wrongful gains from securities markets. Even if those limits are not always clear, they undeniably exist. The principle is partly premised on the idea that in American society, markets are meant to increase the welfare of society.


C.     Translating the Unjust Enrichment Principle into Doctrine

For the unjust enrichment principle to maintain relevance, courts must feel comfortable translating it into doctrine. Though vagueness may be an inevitable shortcoming of the unjust enrichment principle, the doctrinal framework set forth by the Supreme Court in O’Hagan is a useful starting point that, with modification, may be workable.

As noted earlier, O’Hagan can be read as setting forth three elements for a Rule 10b-5 unjust enrichment claim. The unjust enrichment principle applies to (1) deceptive conduct (2) coinciding with a securities transaction (3) that enriches some individual at the expense of others.

The first element—deceptive conduct—increases the range of Rule 10b-5 because unlike the antifraud rule, it does not require a specific misrepresentation or omission directed at the market or investors. Under the unjust enrichment principle, a broader range of conduct—such as theft, manipulation, or an undisclosed special arrangement—is sufficient to trigger Rule 10b-5. Though it attaches to a wider range of conduct, the requirement of deception provides a significant limit to the reach of the unjust enrichment principle.

The second element—the requirement that unjust enrichment coincide with a securities transaction—can also serve as an important limit on the type of wrongful conduct that might trigger Rule 10b-5. Not just any wrongful conduct triggers Rule 10b-5; there must be a substantial connection to a securities transaction. Thus, if someone embezzles money from a bank and invests the money in a stock, that claim might satisfy the deceptive-conduct element of the unjust enrichment test, but the initial theft and subsequent investment would be sufficiently disconnected that the substantial-connection requirement would not be met.

The third element—the requirement of enrichment by an individual—might naturally be limited by the requirement that unjust enrichment occur at the expense of others before liability can be triggered. This third element could be modified so that the difficulty of establishing it might differ based on whether the individual is a fiduciary, agent, or outsider. Given their broadly defined duties to shareholders, fiduciaries might face a rebuttable presumption that wrongful enrichment occurred at the expense of others. Agents and outsiders would not face a presumption, and the plaintiff would carry the burden to prove that the wrongful enrichment occurred at the expense of others.


Conclusion

Rule 10b-5 is now much more than a provision that catches fraud. Although it is primarily an antifraud rule that facilitates efficient markets, Rule 10b-5 is also shaped by an unjust enrichment principle covering deceptive conduct related to a securities transaction that enriches an individual. The increasing use of the unjust enrichment principle has not just expanded the reach of Rule 10b-5; it has limited the rule in important ways. The unjust enrichment principle is a legitimate part of Rule 10b-5, though courts developing Rule 10b-5 doctrine should maintain focus on the first-order goal of promoting efficient markets.

Acknowledgments:

Copyright © 2010 Duke Law Journal.

James J. Park is an Associate Professor of Law at Brooklyn Law School.

This Legal Workshop Editorial is based on the following article: James J. Park, Rule 10b-5 and the Rise of the Unjust Enrichment Principle, 60 DUKE L.J. 345 (2010)

  1. 17 C.F.R. § 240.10b-5 (2010).
  2. Chiarella v. United States, 445 U.S. 222 (1980).
  3. Id. at 234–35.
  4. Earlier articles have noted the relevance of unjust enrichment principles to Rule 10b-5 doctrine. See, e.g., Donald C. Langevoort, Insider Trading and the Fiduciary Principle: A Post-Chiarella Restatement, 70 CALIF. L. REV. 1, 2 (1982) (“Persons in a position to have special access to confidential information bearing on the value of a security are perceived as being unjustly enriched when they trade with others who are unable to discover that information.”); Robert B. Thompson, The Measure of Recovery Under Rule 10b-5: A Restitution Alternative to Tort Damages, 37 VAND. L. REV. 349, 352 (1984) (“Recovery under rule 10b-5 sometimes is supported by tort principles, sometimes supported by unjust enrichment principles, and sometimes by both.”).
  5. See, e.g., Eugene F. Fama, Efficient Capital Markets: A Review of Theory and Empirical Work, 25 J. FIN. 383, 383 (1970) (“A market in which prices always ‘fully reflect’ available information is called ‘efficient.’”).
  6. Irwin Friend, The SEC and the Economic Performance of Securities Markets, in ECONOMIC POLICY AND THE REGULATION OF CORPORATE SECURITIES 185, 187 (Henry G. Manne ed., 1969).
  7. Victor Brudney, Insiders, Outsiders, and Informational Advantages Under the Federal Securities Laws, 93 HARV. L. REV. 322, 334 (1979).
  8. Santa Fe Indus., Inc. v. Green, 430 U.S. 462 (1977).
  9. Id. at 476.
  10. Basic Inc. v. Levinson, 485 U.S. 224, 231–32 (1988) (quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)) (internal quotation marks omitted).
  11. 17 C.F.R. § 240.10b-5 (2010).
  12. Chiarella v. United States, 445 U.S. 222, 224–25 (1980).
  13. See id. at 232 (“No duty could arise from {Chiarella’s} relationship with the sellers of the target company’s securities, for {Chiarella} 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.”).
  14. Id. at 241 (Burger, C.J., dissenting).
  15. United States v. O’Hagan, 521 U.S. 642 (1997).
  16. Id. at 652.
  17. Id. at 653 (alteration in original) (quoting Brief for the United States at 14, United States v. O’Hagan, 521 U.S. 642 (1997) (No. 96-842), 1997 WL 86306) (internal quotation marks omitted).
  18. Id. at 652.
  19. James J. Park, Rule 10b-5 and the Rise of the Unjust Enrichment Principle, 60 DUKE L.J. 345, 369–75 (2010).
  20. Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).
  21. Id. at 193.
  22. Private Securities Litigation Reform Act of 1995 (PSLRA), Pub. L. No. 104-67, 109 Stat. 737 (codified as amended in scattered sections of 15 U.S.C. and 18 U.S.C.).
  23. 15 U.S.C. § 78u-4(b)(2) (2006).
  24. See Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1130 (2d Cir. 1994) (“Motive would entail concrete benefits that could be realized by one or more of the false statements and wrongful nondisclosures alleged.”); see also Ganino v. Citizens Utils. Co., 228 F.3d 154, 170 (2d Cir. 2000) (citing Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124 (2d Cir. 1994), post-PSLRA, for the proposition that “{g}eneral allegations that the defendants acted in their economic self-interest are not enough” to prove motive).
  25. See Ronconi v. Larkin, 253 F.3d 423, 434 (9th Cir. 2001) (“Insider trading goes more directly toward proving that the defendants knew the statement was false than proving that the statement itself was false.”).
  26. Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 325 (2007).
  27. See, e.g., Richard A. Booth, The End of the Securities Fraud Class Action as We Know It, 4 BERKELEY BUS. L.J. 1, 3 (2007) (“A {securities fraud class action} should be dismissed for failure to state a claim unless it appears that insiders have enjoyed gains from trading during the fraud period.”).
  28. See, e.g., James J. Park, Assessing the Materiality of Financial Misstatements, 34 J. CORP. L. 513, 514 (2009) (proposing that courts should focus on the persistence of financial misstatements in assessing their materiality).

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