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Thomas M. Selman^†

This Article presents a novel understanding of the purpose of federal securities laws as the management of investment risk. Those laws should be treated as a whole. When two rules, even under different statutes, address the same risk, they should be applied concomitantly. For example, broker-dealer regulation under the Securities Exchange Act of 1934 might justify relaxation of prospectus delivery requirements in the Securities Act of 1933.

“The [Securities Act] bill is not foolproof. It will not prevent anybody from putting his money into rat holes . . . .” — Congressman Carl E. Mapes^[1]

I. Unsated Curiosity

Mr. Loni Almoni is the ever-punctilious Chief Compliance Officer for Figurative Wealth Management. On October 3, 2016, Almoni reviewed several accounts for Figurative, a registered broker-dealer.[2] Straightening his bowtie,[3] he observed:

• A broker had recommended that customers purchase shares of a registered investment company and shares of an operating company in its initial public offering.
  • Almoni confirmed that the broker had conducted a reasonable inquiry into the securities and his recommendations were suitable.
  • He also confirmed that the prospectus for the registered investment company and the preliminary prospectus for the initial public offering were delivered as required to the customers.
• Some of these customers were accredited investors who had purchased private placements without having received private placement memoranda.
  • Upon consultation with the firm’s legal staff, Almoni confirmed that delivery of private placement memoranda was not required by law.
• The broker also had recommended a private placement to customers who were not accredited investors.
  • Almoni confirmed that a private placement memorandum had been provided to those customers as required, and that the recommendations were suitable.

Almoni believed that he was an expert in the federal securities laws, but he always brought his questions to the legal department.

• Of what benefit is the private placement memorandum to an unsophisticated customer who purchases through a licensed broker?
• Why must Figurative Wealth Management deliver prospectuses about registered investment companies that are comprehensively regulated to customers who are represented by licensed brokers?
• Why must the firm deliver prospectuses to customers who are qualified to buy privately-placed securities without having received any disclosure?

The legal department could not explain the policy behind these requirements but dutifully cited the applicable rules.

A measure applied in one circumstance, such as prospectus delivery to unsophisticated investors, seems unnecessary in another, such as prospectus delivery to accredited investors. Two conditions with seemingly identical purposes, such as prospectus delivery and investor accreditation, are imposed simultaneously without obvious regard for one another.

This Article proposes a new way to understand the securities laws. In Part II, this Article considers their legislative purpose. For the sake of simplicity, this Article gives particular attention to one set of laws that regulate the formation and sale of securities, the “Product and Sales” Provisions.[4] They are administered by the Securities and Exchange Commission (SEC), the self-regulatory organizations, and the only national securities association, the Financial Industry Regulatory Authority (FINRA).

In Part II, this Article explains that the legislative purpose of the Product and Sales Provisions is investor protection. Investor protection is the confrontation of investment risk. In Part III, Product and Sales Provisions are distinguished as those that prohibit bad conduct like fraud and manipulation from “Prescriptive Provisions” that require certain behavior. In Part IV, this Article explains how the Prescriptive Provisions confront investment risk, such as the risks related to an issuer’s business and the markets in which its securities trade. In Part V, this Article argues for a more cohesive understanding of securities law, framed according to investment risk. The Prescriptive Provisions are viewed as a body of law. By considering together measures under different statutes that address the same type of risk, we produce a coherent understanding of the law. Inefficiencies can be reduced, burdens minimized, and gaps exposed. This Article presents two case studies that demonstrate this.

II. Legislative Purpose of Securities Law

Even a cursory review of the federal securities laws and their legislative history will reveal that protection of investors is their principal purpose. A typical, perhaps formulaic description of the SEC’s rulemaking power occurs repeatedly in the federal securities laws: The SEC is to adopt rules that are “necessary or appropriate in the public interest and for the protection of investors.”[5] Sometimes the phrase appears in the disjunctive (“in the public interest or for the protection of investors”) and sometimes in conjunction with other requirements (“in furtherance of this title”).[6] Nevertheless, the frequency with which it appears confirms that the SEC’s central mission is to protect investors.

Stated most generally, the Securities Act of 1933 (Securities Act) advances investor protection through disclosure, the Securities Exchange Act of 1934 (Securities Exchange Act) and the Investment Advisers Act of 1940 (Investment Advisers Act) through the regulation of financial intermediaries, and the Investment Company Act of 1940 (Investment Company Act) through the oversight of investment companies.[7]

One might ask, “From what harm is the investor to be protected?” The statutes hint at one answer: fraud, and inequitable and unfair practices. Some provisions prohibit behavior that is morally or ethically reprehensible, such as fraud, market manipulation, churning of brokerage accounts, and excessive markups on principal transactions. These Product and Sales Provisions are intended, quite simply, to protect investors by eliminating these practices.

Other Product and Sales Provisions prescribe behavior that isn’t morally or ethically laudable but is to be encouraged. One who commits fraud is morally reprehensible; one who fails to make line item disclosures required by Regulation S-K may not be, but there may be a public good in requiring him to do so. The Product and Sales Provisions can be divided between those prohibiting nefarious conduct and others prescribing salutary behavior. The former protect investors from the morally reprehensible conduct. The latter prescribe behaviors whose connection to investor protection is more attenuated. We will call the latter requirements the “Prescriptive Provisions.”

III. The Prescriptive Provisions

The Prescriptive Provisions protect investors from conditions that might cause them harm even in the absence of malevolent conduct. These harmful conditions are implied by the objectives of each statute.

• Disclosure by issuers militates against the potential loss that comes from investing in the dark, from ignorance about the proposed investment. Public disclosure also allows the capital markets to reflect this information in the price of widely-traded securities and to price the “risk premium” associated with the security.[8] Exemptions from the prospectus delivery requirements are provided when investors are deemed qualified to participate without disclosure. The qualification of investors helps to ensure that they have the financial acumen or resources to obtain necessary information about the offering, to evaluate the offering, and to bear the investment risks.
• The regulation of financial intermediaries reduces the possibility that an intermediary will engage in practices that might cause its customers harm. These practices might constitute abject abuse, like fraud and manipulation, or they might devolve from the conflicts of interest that distract the financial intermediary from its responsibilities to the customer.
• The oversight of investment companies addresses the concern that conflicts of interest in their operation or the complexity of their structure might encourage behavior that causes shareholders harm.

In short, the Prescriptive Provisions address risks associated with securities investments.[9] These risks include the possibility of investing in the dark, retaining the services of a financial intermediary with conflicts of interest, and investing in an investment company whose liquid assets might be pilfered or whose shareholder equity might be dissipated. The legislative purpose of “investor protection” may be understood as a response to the risks of buying securities, hiring broker-dealers or investment advisers, and purchasing investment company securities.

IV. How the Prescriptive Provisions Address Investment Risk

The Prescriptive Provisions essentially address two categories of risk, those associated with a financial intermediary and those associated with a security.

Broker-dealers and investment advisers present agency risk, counterparty risk, and competency risk. The Prescriptive Provisions address these risks in varying degrees, agency risk being the most extensive subject of regulation. Agency risk refers to the possibility that financial intermediaries, in performing their financial service, will benefit themselves at their customers’ expense. As discussed more below, FINRA comprehensively regulates the business of a broker-dealer and the Investment Advisers Act imposes a fiduciary duty on investment advisers that requires the investment adviser to act with a duty of care and a duty of loyalty to the customer.[10]

The Prescriptive Provisions also address the risks associated with a security. These are business and market risks, agency risk, and competency risk. Business and market risks include the risks associated with the investment’s business prospects and its operations, those associated with the terms of the security, the risk that those terms will not be enforceable, the risks associated with the conditions under which the security trades, and those associated with economic or political influences on the expected total return. Agency risk concerns the probability that agencies of the issuer will act in their own interest in a manner inconsistent with the interests of shareholders. Competency risk concerns the probability that the managers of the issuer are not competent.

For ease of discussion, we will elaborate only on the business and market risks associated with a security.[11] The Prescriptive Provisions mitigate business and market risks associated with a security through disclosure and the regulation of financial intermediaries.

1. Disclosure

Under Section 10 of the Securities Act, an issuer must register its publicly-offered securities;[12] Section 5 generally requires that a prospectus be provided to investors.[13] The Securities Exchange Act requires that public issuers provide periodic reports concerning their financial condition and material events. Also, the issuer’s financial statements must be audited by an independent public accountant registered with the Public Company Auditing Oversight Board.[14] The periodic reports are “integrated” into the issuer’s registration statements for its follow-on offerings.[15]

This integrated reporting system ensures that the investing public is informed about the condition of the public issuer and its business and market risks. The Prescriptive Provisions respond to the business and market risks through disclosure about matters such as the operation of the issuer’s business, associated risks, the terms of the security, the primary market upon which it will be traded, and economic and political risks.[16]

Disclosure is required in certain private placements too. For example, Rule 506 of Regulation D exempts a private placement from the registration requirements of Section 10 if it will be offered to no more than 35 unaccredited investors or to an unlimited number of accredited investors,[17] provided that unaccredited investors receive disclosure concerning the terms of the offering, risk factors, potential dilution, the plan of distribution, and the issuer’s business.

The Prescriptive Provisions provide exceptions to disclosure requirements for investors who are deemed “qualified.” For example, under Rule 506, accredited investors are presumed to have the financial acumen or resources to obtain necessary information about the security, to evaluate it, and to bear the investment risks.[18] For these investors, disclosure is not required.

2. Regulation of Financial Intermediaries

The regulation of financial intermediaries also addresses business and market risk. The Securities Exchange Act regulates broker-dealers and requires most of them to belong to a regulated national securities association, the only one of which is FINRA.[19] FINRA comprehensively regulates virtually all aspects of a broker-dealer’s operations and requires that a broker-dealer’s recommendations be suitable.[20] The suitability rule requires the broker-dealer to conduct reasonable diligence into the features of the recommended security, including the types of risks enumerated above as “business and market risks.”[21]

Section 11 of the Securities Act imposes strict liability on broker-dealers who participate in the distribution of publicly-offered securities with respect to untrue statements or omissions of material fact in the registration statement. The underwriter may have a defense if it can demonstrate that the underwriter had “after reasonable investigation, reasonable ground to believe and did believe . . . that the statements . . . were true and that there was no [material] omission.”[22] As a practical matter, this defense imposes a due diligence obligation on underwriters. Broker-dealers who serve as underwriters help to address business and market risks by conducting due diligence about the accuracy of the registration statement that discloses information about the issuer.

The Investment Advisers Act imposes a fiduciary duty on registered investment advisers, including a duty of loyalty and a duty of care. According to the SEC, embedded in this fiduciary duty is a suitability obligation similar to the one that FINRA imposes on broker-dealers.[23]

iii.

Investment Company Regulation

The Investment Company Act mitigates business and market risks associated with investment company issuers. The Act comprehensively regulates all aspects of registered investment companies, including their capital structure and organization, the terms of their securities, and the liquidity of their held assets.

To summarize, the Prescriptive Provisions address the business and market risks associated with a security through:

• Disclosure and investor qualification;
• Financial intermediary regulation; and
• Investment company regulation (in the case of investment company issuers).

V. A New Way to Appreciate Securities Law

Securities law can be understood as a response to specific types of investment risk. Provisions in different statutes often address the same type of risk. For example, prospectus delivery and broker-dealer regulation both address the business and market risks associated with a security. Prospectus disclosures bring to light the salient facts about the issuer and security; FINRA’s suitability rule imposes a diligence requirement on broker-dealers when they recommend publicly-issued securities.

These provisions should be considered together. Redundant confrontation of the same risk can be eliminated and gaps in the confrontation of investment risk exposed. Efficiencies in the law’s application would be obtained and burdens on capital formation and financial services minimized.

In short, the Product and Sales Provisions and other identifiable subsets of the securities law should be viewed organically, without regard to the statute in which they happen to appear. A Securities Act provision for prospectus delivery should be considered alongside the Investment Company Act’s regulation of investment companies and FINRA’s suitability rule. The various ways in which they address business and market risk should be contemplated in unison. This understanding of the securities law as an organic body of law would better ensure that they are coherently understood and consistently applied.

To illustrate our proposed method of understanding we will apply it to two examples.

• The business and market risks associated with privately-placed securities recommended by a financial intermediary.
• The business and market risks associated with publicly-offered securities recommended by a broker-dealer.

These examples are concomitant with the conundra of Loni Almoni in Part I.

1. The Purchase of Securities in a Recommended Transaction under Rule 506

Loni Almoni asked, “Of what benefit is the private placement memorandum to an unsophisticated customer who purchases through a licensed broker?” After all, the broker must conduct a reasonable inquiry about a private placement and recommend only suitable investments to the customer.

Rule 506 permits the sale of privately-placed securities to no more than thirty-five unaccredited investors and an unlimited number of accredited investors.[24] Unaccredited investors must receive disclosure concerning the terms of the offering, risk factors, potential dilution, the plan of distribution, and the issuer’s business, including financial information.[25] Each unaccredited investor “either alone or with his purchaser representative(s)” also must have: “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within this description.^[26]

“Purchaser representative” is similarly defined to include any person who “[h]as such knowledge and experience in financial and business matters that he is capable of evaluating, alone, or together with other purchaser representatives, or together with the purchaser, the merits and risks of the prospective investment.”[27] Purchaser representatives may be broker-dealers and investment advisers.[28]

Accredited investors need not receive disclosure nor representation from a purchaser representative.[29] The rule relies on the notion common in the federal securities laws that some investors possess the financial acumen or resources to evaluate the offering and bear the associated investment risks.

Our proposed method of rulemaking requires an integrated analysis of the Prescriptive Provisions. If a provision in one statute mitigates an investment risk, then another rule might defer to it to mitigate the same risk in a different situation. Rule 506 illustrates this integrated understanding of the Prescriptive Provisions. If an unaccredited investor is unsophisticated, then the broker-dealer or investment adviser who recommends the private placement should possess the requisite knowledge and experience. Rule 506 relies on the knowledge and experience of a broker-dealer or investment adviser to evaluate business and market risks of privately-placed securities on behalf of unaccredited investors.

Nevertheless, Rule 506 does not rely on the performance by an intermediary of its suitability and fiduciary obligations. Indeed, Rule 506 does not require a purchaser representative to be a regulated broker-dealer or investment adviser.[30] Regardless, the cohesive assimilation of the broker-dealer and investment adviser into the rule, even limited to considerations of knowledge and experience, is consistent with the method of rulemaking that this Article recommends.[31]

However, this method does present one question. As Loni Almoni inquired, will unsophisticated investors who are represented by a broker-dealer or investment adviser value the private placement memorandum that the rule requires? If broker-dealers and investment advisers are subject to adequate regulation concerning the diligence and suitability of recommendations, why must Rule 506 require delivery of a private placement memorandum to unaccredited investors?[32] At most, perhaps, investors should have the ability to obtain a private placement memorandum upon request.

2. The Purchase of Publicly-Offered Securities in a Recommended Transaction

Loni Almoni asked:

• Why must Figurative Wealth Management deliver prospectuses about registered investment companies that are comprehensively regulated to customers who are represented by licensed brokers?
• Why must the firm deliver prospectuses to customers who are qualified to buy privately-placed securities without having received any disclosure?

The requirement that an investor will receive, or at least have access to a prospectus, is fundamental to the Securities Act.[33] Nevertheless, one might inquire whether prospectus delivery should be required when an investor is represented by a registered broker-dealer.[34] Do the Prescriptive Provisions governing the broker-dealer’s due diligence and suitability responsibilities adequately address the business and market risks associated with the recommended purchase? If they do, then what is the added value of prospectus delivery to a retail investor who is represented by a broker-dealer? Are there other purposes served by prospectus delivery to such an investor?[35] If the due diligence and suitability requirements do not adequately address the business and market risks, then what level of regulation of the broker-dealer’s distribution of publicly-offered securities would ensure that the business and market risks are addressed?[36]

Moreover, the requirement that a retail investor receive or at least have access to a prospectus before the purchase of publicly-offered securities exists regardless of its sophistication or financial resources. Under Rule 506, an accredited investor is not required to receive disclosure concerning a private placement in which it invests.

Why should prospectuses be delivered to accredited investors who purchase publicly-offered securities? If these investors are deemed to have the financial acumen or capacity to analyze the business and market risks associated with privately-placed securities, why can they not analyze the business and market risks associated with registered and publicly-distributed securities?[37]

The public offering of investment company securities leads to more questions. The federal securities laws and FINRA rules impose a suitability obligation upon a broker-dealer that recommends registered investment company securities, as they do upon the recommendation of any other security. Investment advisers must comply with their fiduciary duty when they recommend investment company securities. The fiduciary duty embraces a suitability obligation and a requirement to conduct reasonable diligence about the security.[38]

Under what circumstances must a broker-dealer or investment adviser conduct reasonable diligence about the operation, organization, or structure of an investment company, which the Investment Company Act comprehensively regulates?

To summarize our answers to Loni Almoni:

• Delivery of a private placement memorandum to unaccredited investors represented by a broker-dealer could be duplicative of the protections afforded by the regulation of their broker-dealer.
• Delivery of investment company prospectuses to investors who purchase as a result of their broker-dealer’s recommendation also appears to be redundant.
• Delivery of prospectuses to accredited investors may be unnecessary.

The organic understanding of securities law as a response to investment risk thus could allow a more efficient tailoring of investor protections. The Prescriptive Provisions would operate in a more coherent framework, investors would be better served, and undue burdens on the industry would be removed.

† J.D., Executive Vice President, Regulatory Policy, and Legal Compliance Officer, Financial Industry Regulatory Authority. The views expressed are those of the author and do not reflect the opinions of FINRA or his FINRA colleagues, many of whom would fervently endorse this disclaimer. The author appreciates the provocative commentary of Robert L.D. Colby, Angela C. Goelzer, Alan B. Lawhead, Joseph E. Price, Joseph P. Savage, and Jonathan S. Sokobin.

[1] Mapes continued, “but in the exercise of reasonable care he can . . . [find out the facts.]” 77 Cong. Rec. 2,912 (1933).

[2] And a figurative company.

[3] Almoni also was a fastidious dresser.

[4] The federal securities laws regulate the creation of some securities products. For example, the Investment Company Act of 1940 regulates the design and operation of investment companies. See generally 15 U.S.C. §§ 80a-1–80a-64 (2012). The federal securities laws also regulate the distribution of securities. For example, the Securities Act of 1933 regulates the public distribution of securities. See generally 15 U.S.C. §§ 77a–77mm (2012). The Securities Exchange Act of 1934 requires periodic reporting by public issuers and regulates broker-dealers that recommend and sell securities. See generally 15 U.S.C. §§ 78a–78pp (2012). The Investment Advisers Act of 1940 regulates investment advisers. See generally 15 U.S.C. §§ 80b-1–80b-21 (2012).

For purposes of simplicity, this Article does not include within Product and Sales Provisions the requirements applicable to trust indentures, clearing and transfer agencies, stock exchanges, and alternative trading systems, although these provisions also might be relevant to the manufacture and sale of securities and might advance some of the purposes of the Product and Sales Provisions.

[5] That phrase or one similar to it appears approximately 16 times in the Securities Act, 147 times in the Securities Exchange Act, 16 times in the Investment Advisers Act, and 40 times in the Investment Company Act. hese references appear in Product and Sales Provisions. See, e.g., Securities Act of 1933, 15 U.S.C. §§ 77c(a)(2), 77g(a)(1), 78j(b) (2012); Securities Exchange Act of 1934, 15 U.S.C. §§ 78m(a), 78o(b)(1) (2012); Investment Advisers Act of 1940, 15 U.S.C. §§ 80b-3(c)(1), 80b-4a (2012); Investment Company Act of 1940, 15 U.S.C. §§ 80a-8(a), 80a-12(a), 80a-12(b) (2012).

In the National Securities Markets Improvement Act of 1996, Congress imposed an additional responsibility upon the SEC, to consider whether certain proposed rules will promote efficiency, competition, and capital formation. See Securities Act of 1933, 15 U.S.C. § 77b(b) (2012); Securities Exchange Act of 1934, 15 U.S.C. §§ 78c(f), 78o(n)(2) (2012); Investment Advisers Act of 1940, 15 U.S.C. § 80b-2(c) (2012); Investment Company Act of 1940, 15 U.S.C. § 80a-3(c) (2012).

[6] Id.

[7] According to its preamble, the Securities Act implements “full and fair disclosure of the character of securities sold in interstate and foreign commerce and through the mails, and to prevent frauds in the sale thereof[.]” Securities Act of 1933, pmbl. According to its preamble, the Securities Exchange Act is intended to “prevent inequitable and unfair practices on [securities] exchanges and [over-the-counter] markets.” Securities Exchange Act of 1934, pmbl. Section 1 of the Investment Company Act states that the Act will “mitigate and, so far as is feasible . . . eliminate . . . conditions . . . which adversely affect the national public interest and interest of investors.” 15 U.S.C. § 80a-1(b)(8) (2012).

The Investment Advisers Act describes its objectives with less precision. Section 201 states that the basis for the Act is the use by investment advisers of national securities exchanges, over-the-counter markets and securities issued by banks and companies engaged in interstate commerce, all in such volume as “substantially to affect interstate commerce, national securities exchanges, and other securities markets, the national banking system and the national economy.” 15 U.S.C. § 80b-1(3) (2012).

[8] The notion that information about a company might be reflected in the price of its common stock may have been recognized when the securities laws were enacted. See, e.g., H.R. Rep. No. 73-85, at 3 (1933) (“The items required to be disclosed [by the proposed legislation] are items indispensable to any accurate judgment upon the value of the security.”); H.R. Rep. No. 73-1383, at 11 (1934) (“The disclosure of information materially important to investors may not instantaneously be reflected in market value, but despite the intricacies of security values truth does find relatively quick acceptance on the market.”).

The periodic reports of a public company are available on EDGAR and the market price of the security might be presumed to reflect the information in those reports. See, e.g., Microcap Stock: A Guide for Investors, SEC, http://www.sec.gov/investor/pubs/microcapstock.htm.

[9] They don’t eliminate all investment risk.

[10] The Prescriptive Provisions also address counterparty and competency risks associated with a financial intermediary. See, e.g., Net Capital Requirements for Brokers or Dealers, 17 C.F.R. § 240.15c3-1 (2014); Customer Protection-Reserves and Custody of Securities, 17 C.F.R. § 240.15c3-3 (2013); see also Securities Investor Protection Act of 1970 § 4(c), 15 U.S.C. § 78ddd (2012) (requiring broker-dealers to carry insurance).

SEC rules under the Investment Advisers Act regulate the custody of client assets by investment advisers. Many states impose net capital or surety bond requirements on state registered investment advisers. See, e.g., Cal. Code Regs. tit. 10, § 260.237.2 (2009) (detailing the minimum financial requirements for investment advisers); 950 Mass. Code Regs. § 12.205(5) (2018) (detailing the surety bond requirement placed on investment advisers).

FINRA requires broker-dealer representatives to pass qualifying examinations. See FINRA, Rule 1031, Registration Requirements (2003). Some states require that investment adviser representatives pass qualifying examinations. See, e.g., 950 Mass. Code Regs. § 12.205(4) (2018). Some states provide an exception to investment adviser representatives who have passed examinations offered by certain private organizations, such as the CFA Institute and the CFP Board. Id.

[11] State corporate law typically addresses a company’s agency risk by imposing a fiduciary duty on corporate insiders. See, e.g., J. Macey, An Economic Analysis of the Various Rationales for Making Shareholders the Exclusive Beneficiaries of Corporate Fiduciary Duties, 21 Stetson L. Rev. 23 (1992) (“Under traditional state and corporate law doctrine, officers and directors of both public and closely held firms owe fiduciary duties to shareholder and to shareholder alone.”)

The Prescriptive Provisions also respond to agency and competency risks associated with a public issuer through disclosure. See, e.g., Secs. and Exch. Comm’n, Form S-1 Registration Statement Under the Securities Act of 1933 (2016) (requiring disclosure of director experience and qualifications, legal proceedings, executive compensation, and related party transactions); see also Securities Act of 1933 § 6(a), 15 U.S.C. § 77f (2012); 17 C.F.R. § 240.13a-14 (2009) (requiring the board, the Chief Executive Officer and the Chief Financial Officer to sign the company’s registration statement and annual report); Sarbanes-Oxley Act § 404(b), 15 U.S.C. § 7262 (2012) (requiring officer appraisal of the issuer’s internal controls).

The panoply of Investment Company Act regulations helps to ensure that the organization, structure and operation of investment companies are not vulnerable to insider misconduct. Moreover, the investment adviser to an investment company must be registered under the Investment Advisers Act and investment adviser representatives to a registered investment company must pass qualification examinations. See Exams, North American Securities Administrators Association, nasaa.org/industry-resources/exams (last visited Mar. 13, 2018).

The Prescriptive Provisions also address agency risk through the regulation of financial intermediaries. FINRA’s suitability rule and the investment adviser’s fiduciary duty presumably require financial intermediaries to conduct reasonable diligence about any red flag concerning the disciplinary record and competency of an issuer’s management.

[12] See Securities Act of 1933, 15 U.S.C. § 77j (2012) (requiring delivery of preliminary prospectus in initial public offering).

[13] See id. at § 77e(b)(1) (2012); Delivery of Prospectuses, 17 C.F.R. § 230.172 (2005) (requiring final prospectus to be filed with the SEC or delivered to customer); Notice of Registration, 17 C.F.R. § 230.173 (2005) (requiring underwriter or dealer to give purchaser the final prospectus or a notice that delivery of prospectus would have been required if not for Rule 172); Delivery of Prospectus, 17 C.F.R § 240.15c2-8(h) (2014) (requiring the managing underwriter to take reasonable steps to ensure that selling group members receive final prospectuses so they can comply with the final prospectus delivery requirement).

[14] See Securities Exchange Act of 1934 §§ 12, 13, 15(d), 15 U.S.C. §§ 78l, 78m, 78o(d) (2012); Sarbanes-Oxley Act of 2002 § 102, 107 P.L. 204, 116 Stat. 745 § 102 (2002).

[15] See generally Regulation S-K, 17 C.F.R. pt. 229 (2017).

[16] For example, Form S-1, a form commonly used to register publicly offered securities, requires the following line item disclosure:

Item 1/Item 9 – Description of the securities, including their market.

Item 3 –             Disclosure of risk factors, including the lack of operating history, the financial position, the business or proposed business, and the lack of a market.

Item 11 – Information concerning the registrant, including a description of its business and the securities market, financial information, management’s discussion and analysis concerning the “financial condition, changes in financial condition and results of operations,” and quantitative information about market risk.

Disclosure of underwriting compensation in the registration statement and FINRA regulation of underwriting compensation under its Rule 5110 might also address business and market risk associated with the security. See, FINRA, Rule 5110, Corporate Financing Rule (2016). Cf. 77 Cong. Rec. 2929 (1933) (“Among the most important facts to be learned for determining the real value of a security is the amount of water it contains. And any excessive amount paid to the banker for marketing a security is water.” (quoting Justice Louis Brandeis)).

[17] Rule 501 defines “accredited investor” to include any natural person whose individual net worth, or joint net worth with a spouse, exceeds $1,000,000, or who had income in excess of $200,000 in each of the two most recent years, or joint income with a spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year. See 17 C.F.R. § 230.501 (2016); see also 15 U.S.C. § 80a-3(c) (2010) (registration exemptions for certain investment funds).

[18] As the SEC staff has stated, “The accredited investor definition attempts to identify those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary.” U.S. Secs. & Exch. Comm’n, Report on the Review of the Definition of “Accredited Investor” (2015).

The early legislative history of the Securities Act is silent about whether personal wealth implies financial sophistication. It is possible that Congress exempted private placements for more practical or political reasons. See, e.g., H.R. Rep No. 73-85, at 5 (1933) (“[The Draft Securities Act] carefully exempts from its application certain types of . . . securities transactions where there is no practical need for its application or where the public benefits are too remote.”).

The notion that personal wealth implies financial sophistication apparently arose from the 1953 Supreme Court decision in SEC v. Ralston Purina Co., 346 U.S. 119, 125 (1953), in which the Court held that the statutory private placement exemption was intended to apply to purchasers who are “able to fend for themselves.” See Greg Oguss, Should Size or Wealth Equal Sophistication in Federal Securities Laws?, 107 NW. U. L. Rev. 285, 287 (2012).

[19] See Securities Exchange Act of 1934, 15 U.S.C. § 78o(b)(8) (2012).

[20] See FINRA, Rule 2111, Suitability (2014).

[21] Supplementary Material .05(a) of Rule 2111 states, “A member’s or associated person’s reasonable diligence must provide the member or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy.” Id.

[22] See Securities Act of 1933, 15 U.S.C. § 77k(b)(3) (2012).

[23] U.S. Secs. and Exch. Comm’n, General Information on the Regulation of Investment Advisers (2011), https://www.sec.gov/divisions/investment/iaregulation/memoia.htm (“As fiduciaries, investment advisers owe their clients a duty to provide only suitable investment advice.”) (citing Suitability of Investment Advice Provided by Investment Advisers; Custodial Account Statements For Certain Advisory Clients, Investment Advisers Act Release No. 1406, 17 C.F.R. 275 (Mar. 22, 1994).

[24] See 17 C.F.R. § 230.506(b) (2013).

[25] See 17 C.F.R. § 230.502(b) (2016).

[26] 17 C.F.R. § 230.506(b)(2)(ii) (2013).

[27] 17 C.F.R. § 230.501(i)(2) (2016).

[28] See, e.g., id. at § 230.501 n.1 (“A person acting as purchaser representative should consider the applicability of the registration and antifraud provisions relating to brokers and dealers under the Securities Exchange Act of 1934 . . . and relating to investment advisers under the Investment Advisers Act of 1940.”).

[29] However, the SEC encourages issuers to provide accredited investors with this information. See 17 C.F.R. § 230.502(b)(1) (2016).

[30] But see supra note 27.

[31] Cf. 15 U.S.C. § 77d-1 (2012) (a crowdfunding intermediary must register with the SEC and self-regulatory organization as a broker-dealer or funding portal).

[32] Of course, if the regulation or oversight of broker-dealers and investment advisers is inadequate to ensure that their inquiry is reasonable and their recommendations are suitable, then the regulation and oversight should be improved.

[33] It applies whether the customer acts alone or through a financial intermediary. It is distinguishable from the requirements for secondary market transactions, in which a financial intermediary may recommend that a customer purchase the securities of a public company without ensuring that the customer has received or has access to the issuer’s periodic reports, even though the purchase will present business and market risks.

[34] Cf. Milton Cohen, “Truth in Securities” Revisited, 79 Harv. L. Rev. 1340, 1385 (1966).

[T]he 1934 Act says that all “investors” . . . in actively traded securities need the protection of a disclosure system, and that public filing on a continuous basis is essential, and at the same time is adequate, for that purpose. Regardless of dollar amounts or numbers of investors involved, of participation of intermediaries or other particular circumstances, there is no requirement (except in proxy solicitations) that information be culled from the file and physically delivered. If the law is right in saying that this is good enough for investors in the trading markets, why is it not good enough for offerees in a somewhat arbitrarily defined “public offering”?

(footnote omitted) (emphasis in original). Cohen’s article led to the integrated disclosure system. See Adam Pritchard, Revisiting ‘Truth in Securities’ Revisited: Abolishing IPOs and Harnessing Private Markets in the Public Good, 36 Seattle U. L. Rev. 999 (2013).

[35] Prospectus disclosure concerning a new issuer that has not begun to issue periodic reports ensures that information concerning it reaches the marketplace. In a seminal article on the subject of disclosure under the federal securities laws, Milton Cohen explained that because the Securities Act preceded the Securities Exchange Act, public offering disclosure is separate from periodic reporting disclosure. See Cohen, 79 Harv. L. Rev. Some have proposed company rather than securities registration. Id.; see also American Law Institute. FED SEC. CODE (1980). The adoption of the integrated disclosure system for the two Acts moved disclosure toward the concept of company registration. See Pritchard, 36 Seattle U. L. Rev., at 1000.

[36] Cf. Cohen, 79 Harv. L. Rev., at 1408.

The crucial question, obviously, is the appropriate application of “1933 Act” concepts to issuers that are already “1934 Act” continuous registrants. Rightly viewed, it is not a question of weakening the prohibitions of the 1933 Act but rather of strengthening those of the 1934 Act’s continuous disclosure system – the basic system – and then eliminating 1933 Act burdens that are essentially superfluous.

[37] Cf. 15 U.S.C. § 78l (2012) (requiring registration and periodic reporting by companies with either 2000 record holders or 500 unaccredited record holders).

[38] See supra notes 21, 23.

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Janet Austin^†

Governments worldwide are increasingly recognizing that assisting the development of start-ups and small to medium enterprises may be critical to fostering job creation and economic growth. As such, there is a concerted effort to rework securities regulation to encourage the funding of these businesses through innovative approaches such as crowdfunding. However, one major problem with investing in securities issued through crowdfunding is that investors typically have limited-to-no ability to sell the securities. There are a number of over-the-counter, venture and small company markets trying to bridge that gap and proposals in some countries to develop new markets for these types of securities. However, such markets present significant regulatory challenges, as they have historically been plagued by fraud and “pump and dump” manipulation schemes. This Article considers these regulatory challenges and explores how regulators can work to improve the integrity of these markets as a way of encouraging their development.

I. Introduction

Traditionally, start-ups and small to medium enterprises (SMEs) have had to turn to bank financing to fund both their establishment and expansion. However, obtaining debt financing can be challenging. Many entrepreneurs, particularly those in the tech industry, do not have the available assets required as collateral for a loan. Furthermore, paying interest means that a reliance on bank financing reduces cash flow, which can impact the ability of the business to grow while at the same time hinder its capacity to withstand economic downturns.

Faced with stagnant employment rates, governments are increasingly asking their regulatory agencies to look at novel ways to encourage the funding of start-ups and SMEs.^[1] Because statistics show that these businesses are significant employers, their development can be pivotal to both the growth of an economy and the creation of new jobs.^[2]  For example, in the United States, in the wake of the global financial crisis, there were calls from politicians from both political parties to change the structure of securities regulation to encourage the funding of small businesses to stimulate growth and employment.[3] This ultimately led Congress to pass the Jumpstart Our Business Startups Act (JOBS Act), signed into law in 2012.^[4] The JOBS Act directed the U.S. Securities and Exchange Commission (SEC) to make a number of important changes that were designed to increase sources of funding for small businesses. One significant change was that it asked the SEC to develop rules allowing equity crowdfunding.^[5] Many other countries have also recently introduced rules to allow equity crowdfunding for small enterprises.^[6]

However, despite this current enthusiasm for equity crowdfunding, one factor which may significantly hinder equity crowdfunding development is the lack of an exit strategy for investors. Investors purchasing securities via an equity crowdfunding issue are usually locked into their investment and almost invariably cannot quickly sell such securities through a secondary market or exchange if their investment preferences change.[7] Over time, this inflexibility may temper the willingness of investors to participate in such ventures. The lack of a secondary market may also limit the attractiveness of equity crowdfunding for entrepreneurs as a funding strategy given that they will not be able to readily unlock some of the value in the firm by selling their own securities.

A solution is to enable securities issued through an equity crowdfunding campaign to be sold via a secondary market such as an exchange or market specifically designed to trade securities issued by smaller companies. However, compared to the large stock exchanges, such secondary markets face a number of significant challenges. One is that there is generally less trading in the securities of a small company often simply because of the limited number of securities on issue. This can lead to a significant spread between the price at which a seller is willing to sell those securities and the price at which a buyer is willing to purchase them.[8]

This lack of liquidity can also make those securities vulnerable to manipulation, as a lack of supply makes it easier to artificially drive up the price dramatically with relatively few low-value trades. This kind of manipulation frequently takes the form of what is colloquially called a “pump and dump” manipulation scheme. In such a scheme, the manipulator gradually acquires a large number of securities in a particular company. Positive false or misleading information is then disseminated about the company. This may be accompanied by a flurry of matched purchases and sales between associates to give the appearance of heightened interest in the securities, which in turn has a tendency to further artificially inflate the price. When the price of the securities has become inflated, the manipulator sells, that is “dumps,” the securities before the price falls back to a more realistic level.

Because securities traded on secondary markets created for smaller companies are susceptible to manipulation, these markets can be prone to developing a poor reputation that can result in unpopularity among brokers and investors. In addition, regulators responsible for maintaining the integrity of such markets have been forced to devote significant resources to detecting, investigating, and prosecuting such schemes in order to clamp down on abuse in these markets.[9] The task of tackling such abuse has become even more challenging in recent years because the growth of worldwide electronic trading has meant that in many instances, the manipulators are situated outside of the jurisdiction. Rampant abuse has even led to the closing of such markets, which occurred in the case of the First Board of the Open Market in Germany.^[10]

This Article considers the challenges for markets designed for the trading of securities of smaller companies and, in particular, their vulnerability to fraud and market manipulation. It argues that safeguarding the integrity of such markets by eliminating, or at least minimizing, such abuse is a necessary part of ensuring the success of new innovations in the financing of smaller companies such as equity crowdfunding. To this end, this Article also suggests ways in which the integrity, and hence the reputation, of those markets can be enhanced. Part II briefly outlines the recent shift in securities regulation to facilitate the funding of start-ups and SMEs, as well as the growing recognition that secondary markets are needed to enable the trading of the anticipated “tsunami” of securities to be unleashed by these changes.^[11] Part III considers venues which currently exist to trade such securities as well as proposals for the creation of new markets. Part IV describes how historically, markets for secondary trading of securities issued by smaller companies have frequently suffered from an unenviable reputation and as a direct consequence, have struggled to attract investors. Nevertheless, this kind of negative reputation is not inevitable. As such, Part V proposes possible ways in which the credibility of those markets can be enhanced by way of the structure of the market, obligations on market participants, and enforcement mechanisms calculated to deter those tempted to engage in fraud and abuse.

II. Facilitating Equity Funding for Small Companies

The early 21^st century is shaping up to be one characterized by rapid technological advances which can disrupt traditional industries. The demise of such industries can, in turn, result in significant job losses which may impact the social cohesion of society, resulting in political upheaval with governments finding themselves under pressure to generate solutions to tackle unemployment and underemployment.

Rather than resort to protection of traditional industries, one response has been to encourage the development of start-ups and SMEs which are known to be significant job creators. As such and as discussed below, an idea that has gained significant traction in recent years is that of loosening securities regulations to enable smaller companies to more readily raise equity capital rather than having to rely on debt finance. One approach which is becoming increasingly popular throughout the world is for regulations to be relaxed so smaller companies can raise capital through equity crowdfunding.

Equity crowdfunding allows a company to obtain funds from a large body of investors whereby each investor provides only a small amount of the funds required in exchange for securities in the company. A key feature of this approach is the use of the Internet to gather investors, with a licensed Internet platform typically being used to match investors with ventures seeking finance. Use of the Internet platform technology reduces search costs associated with finding appropriate investors.^[12] Another advantage of equity crowdfunding for entrepreneurs is that they are able to maintain management control because ownership of the issued securities is dispersed across many investors. In contrast, raising funds by way of venture capital or private equity typically means that the entity or entities providing the finance will tend to have significant sway over the management and direction of the company. Equity crowdfunding may also enhance the profile of a company as investors become customers whose positive experiences may inspire them to invest in the business and who, in turn, may disseminate information about the company and its products through social media.^[13]

It is also possible that equity crowdfunding may address another issue that has arisen in recent years—in many countries, there has been a marked fall in the number of initial public offerings (IPOs) and, in particular, smaller IPOs.^[14] This has resulted in retail investors being effectively locked out of investing in innovative start-ups during what may be their most rapid-growth phase. Presently, well-developed private equity and venture capital markets supply most of the funding for new high-tech enterprises, with such start-ups only going public after they are well-established.^[15] Equity crowdfunding may allow smaller investors to “get in on the ground floor” of what might be the next Apple or Facebook and thereby experience a substantial return on their investment if these companies rapidly expand.^[16]

In the United States, the JOBS Act directs the SEC to develop rules to allow equity crowdfunding. The SEC released the final rules in 2015 which went into effect in 2016.^[17] Many other countries have recently altered their securities regulation to allow equity crowdfunding, including the UK,^[18] France^[19] and New Zealand in 2014,^[20] Germany in 2015,^[21] Canada in 2016,^[22] and Australia in 2017.^[23] At the same time, while the equity crowdfunding industry is arguably still in its infancy, the number of Internet platforms offering equity crowdfunding is growing, and it is anticipated that it will continue to expand.^[24] Similarly, the funds raised by equity crowdfunding are expected to grow exponentially over the coming years.^[25]

However, the development of the equity crowdfunding industry is likely to be hindered unless the investors who subscribe to equity crowdfunding issues are able to onsell their securities. At present, unlike investors who obtain securities by subscribing to a registered prospectus, investors who subscribe for securities in a crowdfunding issue usually cannot onsell their securities to the public. As such, crowdfunding investors are generally locked in and must wait until the company either has an IPO or is taken over before the funds invested are returned to them. Unless this issue is addressed, over time, crowdfunding may be relegated to the position of a niche industry with most investors avoiding equity crowdfunding issues due to the inability to sell their securities quickly.

III. Venues for Secondary Trading

To address this issue of investors being unable to sell their securities, there appears to be a renewed focus on establishing markets or exchanges for the secondary trading of securities issued by smaller companies. For example, in 2013, the SEC Advisory Committee on Small and Emerging Companies recommended the creation of a separate U.S. equity market for smaller companies and start-ups.^[26] Following this recommendation, a number of SEC Commissioners suggested that the SEC consider approving one or more venture or regional exchanges with relaxed disclosure and other rules specifically designed for smaller companies.^[27]

In other parts of the world, new venues for trading smaller companies are already emerging.^[28] For example, in 2015, the New Zealand Stock Exchange launched a new market known as the NXT Market.^[29] The NXT Market replaced the NZX Alternative Market, which was established in 2003 but struggled with low trading volumes.^[30]  The NXT Market is aimed at small- to mid-sized businesses with a market capitalization of $10–100 million. These companies are required to have at least fifty members of the public as shareholders who cumulatively hold at least a quarter of the shares. There is a simplified disclosure regime with a focus on key operating milestones by which investors can measure and monitor the performance of the company. Each company must also use an NXT-registered adviser for the first three years. ^[31]

Another New Zealand market is also gearing up to deal with securities issued through crowdfunding. A market called “Unlisted” operates under an exemption to the Financial Markets Conduct Act 2013 (FMC Act). As such, investors trading in securities quoted on this market do not receive the kind of protections provided by the FMC Act.^[32] In 2016, Armillary Private Capital, the company that manages the Unlisted market, launched a licensed equity crowdfunding platform called Crowdsphere. As such, Armillary Private Capital can now offer equity crowdfunding services as well as the capacity to trade securities issued through equity crowdfunding via the Unlisted market.^[33]

The Korea Exchange, the sole securities exchange operator in South Korea, has opened a market to trade crowdfunded securities called the “KRX Startup Market” and is geared to attract companies by offering equity crowdfunding combined with the capacity to trade such securities.^[34] As these companies grow, the Korea Exchange can enable them to progress to KONEX (Korea New Exchange) and finally to the Korea Exchange’s principal exchange, the KOSDAQ.^[35]

In Taiwan, although the Taipei Exchange is not directly engaged in crowdfunding, it has set up a platform to link businesses and crowdfunding providers.^[36] Undoubtedly, this was implemented with the hope that as those companies grow they will eventually look to list on its exchange.

Although there is this renewed enthusiasm for establishing new exchanges or markets for the secondary trading of securities issued by smaller companies, globally there already exists a number of markets and exchanges with differentiated admission and disclosure standards to cater to the trading in the securities of SMEs. These have had varied degrees of success.

For example, the U.K. is home to what may be one of the most successful markets for SMEs, namely the Alternative Investment Market (AIM), owned by the London Stock Exchange and created in 1995. Since its inception, over 3,600 companies have listed on it, although the number of companies seeking a listing has fallen to just 47 new listings in 2015 from a high of 399 new listings in 2005.^[37] To list on AIM, each company must appoint and retain a Nominated Advisor, referred to as a NOMAD, at all times. A NOMAD is a firm of experienced corporate finance professionals who are approved by the London Stock Exchange. There are no minimum criteria in relation to listing in terms of the company size, track record, country of origin or set number of shares to be allocated to the public. Rather, the determination for whether the company is appropriate for the market is decided by the NOMAD.^[38]

In the United States, securities not listed on the major exchanges can be traded over-the-counter (OTC), principally by services provided by the OTC Markets Group and through the OTC Bulletin Board (OTCBB) operated by the Financial Industry Regulatory Authority (FINRA). The OTCBB is an inter-dealer quotation system that is used by subscribing FINRA members to reflect market-making interest in OTCBB-eligible securities.^[39] The OTC Markets Group operates three financial marketplaces: (i) the OTCQX, the top tier marketplace with the most stringent eligibility and disclosure standards; (ii) the OTCQB, the venture stage marketplace for medium-sized or early-stage companies; and (iii) the OTC Pink, which comprises the lowest tier of the three marketplaces and features no reporting requirements.^[40] These marketplaces require less disclosure and impose much lower fees than other U.S. exchanges and markets.^[41]

In Canada, the Canadian Securities Exchange (CSE) provides a venue for the trading of microcap and emerging companies and has relatively few reporting and listing requirements.^[42] It has over 300 listed companies and has recently grown due to the listing of a number of start-ups in the cannabis industry.^[43] Canada is also home to the TSX Venture Exchange, which is designed for smaller cap companies, particularly those in the mining as well as oil and gas industries.^[44]

Other significant markets and exchanges for smaller companies include the Euronext Growth market in Europe,^[45] the Shenzhen Stock Exchange SME Board in China,^[46] the BSE SME platform in India,^[47] the AIM Italia in Italy,^[48] and the Tokyo PRO market in Japan.^[49]

IV. Regulatory Challenges in Relation to Secondary Markets for Smaller Companies

Despite the call for new exchanges and markets to trade securities issued by smaller companies, historically such markets have faced a number of significant challenges. These include the fact that some markets, particularly those which are more junior markets of the larger exchanges, gradually become populated by what could be seen as unsuccessful companies. This is because over time, successful firms graduate to larger exchanges, and companies in the larger exchanges that decline in value, sometimes referred to as “fallen angels,” may be relegated to the junior market.^[50] In some cases this poor reputation, coupled with high levels of fraud, has led to the closing of such markets, as occurred with the Emerging Company Marketplace, the junior board of the American Stock Exchange, which opened in 1992 and closed in 1995, after only three years of operation.^[51]

Another significant problem is a lack of liquidity for markets designed to trade the securities of smaller companies. Having fewer securities on issue means that it becomes more difficult for those securities to be bought or sold, as a buyer may find that there is just no one willing to sell securities at the price the buyer is willing to pay and vice versa. This illiquidity can also make securities sold on those markets particularly susceptible to pump and dump manipulation schemes.^[52]

A plague of pump and dump schemes led to the closing of the First Board of the Open Market in Germany in 2012. The Open Market is a multilateral trading facility run by Deutsche Börse that used to be divided into First and Second Quotation Boards. The First Quotation Board, which was designed for smaller companies, had few listing and post-admission requirements. Admission was granted on application by an entity authorized for trading, normally a securities trading bank, and it was considered sufficient if an auditor confirmed the entity had equity of at least €500,000 with each share of at least €0.10 par value.^[53] Over time, it became clear to Germany’s securities regulator, Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), that the majority of the cases of market manipulation that it investigated each year were pump and dump schemes occurring in this market.^[54] These cases were frequently complex and difficult to investigate, had the potential to inflict substantial damage to investors and often involved extensive cross-border activity, as many of the companies whose shares were used in this way came from abroad, particularly Switzerland and the UK.^[55]

Because of the level of manipulation in the First Board of the Open Market, BaFin gradually became critical of the listing requirements.^[56] Initially, Deutsche Börse’s response was to tighten listing standards and to suspend trading in the shares of entities that did not meet those standards.[57] However, prompted by an onslaught of new incidents of suspected market manipulation, in December 2011, Deutsche Börse decided not to admit any new entities to the First Quotation Board and closed it down in 2012.^[58]

In the United States, most of the market manipulations prosecuted by the SEC each year are pump and dump schemes in the OTC markets. While the details of these schemes vary, they typically follow the same pattern of a person taking a large stake in the target company. The person then “pumps” the securities by way of igniting interest via matched orders between associates and promoting the securities in false or misleading emails, Internet postings or social media postings.^[59]

The approach of U.S. authorities in tackling the relatively high volume of such schemes in the OTC markets has been to utilize a specialized unit within the SEC to identify and suspend trading in the securities of dormant companies before they can be hijacked and used for pump and dump schemes.[60] Second, the Federal Bureau of Investigation (FBI) has engaged in sting operations, whereby an undercover FBI agent offers bribes to fund managers in exchange for those fund managers using investors’ funds to purchase penny stocks.^[61] Third, the SEC has worked with the U.S. Department of Justice to criminally prosecute recidivist pump and dump scheme promotors with a view to those promotors being convicted and sentenced to lengthy prison terms.^[62] Finally, FINRA has been active in taking action against brokers who have facilitated manipulative trading in these markets in an effort to deter brokers from acting for clients engaging in this type of illegal conduct.^[63] 

Nevertheless, despite these efforts, pump and dump manipulation schemes still appear to be a problem for U.S. OTC markets. In 2015, the SEC took action in relation to nineteen cases of manipulation that were primarily pump and dump schemes.^[64] _­Like BaFin, the SEC has found that these schemes are often complex and frequently involve accounts or corporations located in foreign jurisdictions such as the British Virgin Islands, Anguilla, the Bahamas, and Turks and Caicos, presumably in an attempt to avoid detection by U.S. regulators.^[65]

This prevalence of manipulation in markets for trading securities issued by smaller companies presents a festering problem going forward if these same markets are to be utilized to trade the expected significant increase in securities generated by equity crowdfunding. A recent survey by the World Federation of Exchanges found that a solid regulatory framework designed to enhance the integrity of the market, coupled with strong supervision and enforcement, is a very important requirement for both investors and companies if they are to participate in markets for SMEs.^[66] As such, it appears that unless action is taken to deter fraud and manipulation in these markets, they are likely to be avoided by investors. Therefore, it is critical to their success, and ultimately the success of equity crowdfunding, that there is an unwavering focus on minimizing fraud and manipulation in regulations governing both the design and ongoing supervision of these markets.

V. How to Enhance the Integrity of Markets for Smaller Companies

Eliminating unfair trading practices such as fraud and market manipulation is pivotal in achieving two of the main objectives of securities regulation—to protect investors and to ensure markets are fair, efficient and transparent.^[67]  One of the most important ways in which regulators endeavor to meet these objectives is by imposing comprehensive listing requirements and thereafter continuous disclosure requirements on companies listed on the large exchanges. This is backed up by the threat of criminal and civil liabilities for failing to provide such information or for providing false or misleading information.

However, for small companies the cost of these kinds of comprehensive listing and disclosure requirements is prohibitive. The real challenge then is for securities regulators to protect investors and preserve the integrity of markets for the trading of securities issued by smaller companies in the absence of a full disclosure regime. While there appears to be no one solution to this problem, there are some mechanisms that could be employed, which may go some way to enhancing the integrity of these types of markets and protecting the investors who use them.

          A. Vetting of Companies

In the absence of comprehensive disclosure requirements, some degree of vetting needs to be imposed on companies to reduce the potential for outright fraud. The cheapest and perhaps most effective way for this to occur may be to make a market intermediary responsible for conducting due diligence to determine the bona fides of the company and its management team. This model has been used by some of the existing markets for small companies, including the AIM, which requires companies to use a NOMAD.^[68] The advantage of requiring a market intermediary to vet companies is that most companies utilizing equity crowdfunding will already have a relationship with a licensed financial service intermediary, namely the licensed crowdfunding platform it used for the issue of its securities. Some of these crowdfunding platforms already undertake due diligence on projects listed on their portals. This can include background checks, site visits, credit checks, account monitoring, and proof of transactions obtained from third parties.^[69] As such, it seems like a logical step that such a firm could also serve to vet the company for listing.

Linking the reputation of the market intermediary to the companies it authorizes for listing should help ensure the quality of the companies traded on the exchanges and minimize the prospect of outright fraud. Of course, the effectiveness of the vetting process is arguably compromised, to some extent, in that the market intermediary is in a fundamental conflict of interest because the company to be vetted engages it and pays for its services. In fact, some argue that conflicts of interest and poor monitoring of NOMADs have led to the failure of many companies listed on the AIM.^[70] Accordingly, for such a regime to be effective, it is critical that market intermediaries be coherently regulated and supervised by regulators. Subjecting market intermediaries to harsh penalties for failure to properly conduct their due diligence responsibilities would also further reduce the prospects of fraud by the company to be listed or its management team.^[71]

          B. Disclosure of Substantial Shareholders

There is a strong argument in support of strict regulations to ensure that changes to substantial shareholders are rapidly and clearly disclosed, coupled with significant penalties for a failure to do so. This is because pump and dump schemes are usually characterized by a person and his or her associates gradually accumulating a significant holding in a stock. Disclosure of changes to holdings by substantial shareholders should alert market participants and the authorities to potential schemes and, as such, strict requirements to disclose substantial shareholdings may tend to deter those contemplating this type of manipulation.

          C. Liquidity and Market Surveillance

Improving the liquidity of markets for the trading of securities issued by smaller companies should significantly reduce the ability of perpetrators of pump and dump schemes to radically increase the price by virtue of there being a lack of supply of securities. Some suggestions that have been made for improving liquidity of such markets include:

• changing trading so that it is not continuous but only takes place in batch auctions at various intervals;^[72]
• altering the tick size of trades to encourage market makers who traditionally have provided liquidity in the markets in which they operate;^[73] and
• ensuring all of the trading of a particular company’s securities is concentrated in one venue and not fragmented over a number of markets or by off-exchange, internal order matching by brokers.^[74]

Concentrating the trading of a company’s securities in one market also has a significant advantage for the authority responsible for detecting manipulation and other abusive practices. This is because currently, the main method by which market manipulation and insider trading is detected is via surveillance software used by the authorities. This software monitors trading on the markets and is designed to identify anomalous trading patterns. If the trading takes place in only one venue, this substantially simplifies the surveillance software systems needed for such detection. By way of comparison, if trading is fragmented over a number of different venues, to effectively conduct such surveillance, trading and order information from each of those markets needs to be collected and assembled before it can be analyzed. This significantly adds to the cost and complexity of the surveillance systems required, not to mention delays the entire analysis process.^[75]

Of course, concentrating all trading within one trading venue creates a monopoly and could potentially result in that venue extracting excess profits from brokers and listed companies. However, the benefits of concentrating all trading in one venue for thinly-traded stocks seem to outweigh this possible disadvantage. Furthermore, given the fact that there are many venues for smaller companies to list their securities around the world, competition between venues should keep in check the possibility of extracting monopoly profits.

          D. Enforcement

If the probability of wrongdoing being detected is high and the penalties are substantial, potential perpetrators will tend to be deterred from engaging in such conduct. Accordingly, it is essential that there be robust laws prohibiting fraud and manipulation coupled with significant penalties for violations, including the possibility of lengthy prison terms. However, this is not enough by itself. It is also necessary for there to be a high probability of both detection and prosecution, rather than just a theoretical risk.^[76]

In addition to detection via market surveillance systems, another important detection method can be reports made by market intermediaries. In particular, regulations need to require that compliance systems be maintained by market intermediaries. These regulations should also impose on market intermediaries an obligation to immediately report suspicious transactions directly to the authorities. Ideally these reports should be made directly to the securities regulator responsible for taking action against market manipulation. In Europe, for example, market intermediaries are required to report directly to the regulator any suspicious transactions, including suspicious unexecuted orders. Failure to do so attracts a penalty of up to €1 million for a natural person and €2.5 million, or 2% of turnover, for other legal persons.^[77] European securities regulators are also required to forward a copy of any suspicious transaction report to all other supervisory authorities of organized securities markets within the EU who may be affected by the report. Over time, such reports are proving to be an important way in which European securities regulators detect market manipulation.^[78]

Another increasingly important detection mechanism for fraud and manipulation is voluntary reports from the public to securities regulators in the form of complaints, tip-offs, or whistleblowers. Such reporting appears to be significantly enhanced when the regulator offers monetary awards to whistleblowers, as is the case with the SEC and the Ontario Securities Commission.^[79] These awards are most commonly made to individuals who have inside knowledge of the fraud, but can also be made to anyone who provides the regulator with original information derived from independent information or independent analysis.^[80]

After initial detection, it is necessary that securities regulators be in a position to rapidly take action against the perpetrators of the abuse, even if those persons are outside of the jurisdiction. Currently, when a perpetrator is outside of the jurisdiction, most securities regulators can obtain access to the information they require to undertake an investigation relatively quickly via a memorandum of understanding established by the International Organization of Securities Commissions (IOSCO), which almost all the securities regulators in the world have signed.^[81] However, a perpetrator can only be brought before the courts if an extradition arrangement is in place or the regulator where the perpetrator is situated is itself prepared to bring a prosecution. If neither occurs, apart from perhaps having assets frozen within the jurisdiction, the perpetrator will escape jail and perhaps even be emboldened to offend in the future. Given the risk to the integrity of the markets that fraud and manipulation pose, securities regulators should consider restricting access to the market from all persons who reside in countries where there is no extradition treaty or where the authorities in that country will not bring their own proceedings against the perpetrators.

VI. Conclusion

For equity crowdfunding to continue to grow, it will be necessary for secondary markets to be developed for smaller companies and for such markets to succeed and thrive. A critical aspect of the success of such markets will be ensuring that investors have the confidence to trade in those markets without an unreasonable risk of becoming the victim of fraud or manipulation.

It is possible to have successful markets for the trading of securities issued by smaller companies, but there must be a clear focus on ensuring the integrity of those markets. This can be achieved by careful design of regulations and the structure of the market with a view to preventing fraud and manipulation schemes. Furthermore, the authorities need to demonstrate to market participants, including those contemplating engaging in manipulation, that any fraud or manipulation in the market will be rapidly detected and effectively prosecuted.

† Associate Professor, University of New Brunswick, Canada.

[1] See, e.g., Communication from the Commission to the European Parliament, The Council, The European Economic and Social Committee and the Committee of the Regions’ Entrepreneurship 2020 Action Plan: Reigniting the Entrepreneurial Spirit in Europe, COM (2012) 795 final (Sept. 1, 2013).

[2] For example, in the EU, it is estimated that SMEs employ two out of every three people and produce 58 cents in every euro of value-added. Patrice Muller et al., A Partial and Fragile Economy: Annual Report on European SMEs 2013/2014 6 (2014). In the US, it is estimated that small businesses have provided 55% of all jobs and 66% of all net new jobs since the 1970s. Manage Your Finances, U.S. Small Bus. Admin. (2017), https://www.sba.gov/managing-business/running-business/energy-efficiency/sustainable-business-practices/small-business-trends.

[3] Andrew Fink, Protecting the Crowd and Raising Capital Through the CROWDFUND Act, 90 Univ. Detroit Mercy L. Rev. 1, 2 (2012).

[4] See Jumpstart Our Business Startups Act of 2012, Pub. L. No. 112–106, 126 Stat. 306 (2012).

[5] Id. at 20. Another important change is commonly known as a Regulation A+ reform. This increased the amount that could be raised using a mini registration statement, rather than a full prospectus, from $5 million in a 12-month period to $50 million. See id. at 401–02.

[6] See infra Part III.

[7] For example, in Canada, investors who purchase crowdfunding securities can usually only sell those securities through utilizing an exemption from the requirement to issue a prospectus. See Prospectus and Registration Exemptions, Nat’l Instrument 45-106 (Can.). In relation to restrictions on selling crowdfunded securities in the United States, see U.S. Secs. and Exch. Comm’n, Regulation Crowdfunding: A Small Entity Compliance Guide for Issuers (2016), https://www.sec.gov/info/smallbus/secg/rccomplianceguide-051316.htm.

[8] Luis A. Aguilar, Comm’r, U.S. Secs. and Exch. Comm’n, The Need for Greater Secondary Market Liquidity for Small Businesses, Public Statement to the Advisory Committee on Small and Emerging Companies (Mar. 4, 2015), https://www.sec.gov/news/statement/need-for-greater-secondary-market-liquidity-for-small-businesses.html.

[9] See infra Part IV.

[10] Id.

[11] See Kay Koplovitz, One Year After Title II and Equity Crowdfunding, Huffington Post (Oct. 10, 2014), http://www.huffingtonpost.com/kay-koplovitz/one-year-after-title-ii-a_b_5965466.html.

[12] World Fed’n of Exchs., SME Financing and Equity Markets 36 (2017), https://www.world-exchanges.org/focus/index.php/features/research/111-wfe-publishes-report-into-sme-financing-equity-markets.

[13] See Alma Pekmezovic & Gordon Walker, The Global Significance of Crowdfunding: Solving the SME Funding Problem and Democratizing Access to Capital, 7 William & Mary Bus. L. Rev. 347, 384 (2016).

[14] See U.S. Sec. Exch. Comm’n, Rebuilding the IPO On-Ramp: Putting Emerging Companies and the Job Market Back on the Road to Growth 1 (Oct. 20, 2011), https://www.sec.gov/info/smallbus/acsec
/rebuilding_the_ipo_on-ramp.pdf.

[15] Chris Brummer has analyzed the reasons why this has occurred. In brief, it seems that reduced regulatory requirements and technological innovations have led to the growth of the private placement market. At the same time, listed public companies have been subject to additional layers of reporting and corporate governance requirements, decreasing the attractiveness of going public. See Chris Brummer, Disruptive Technology and Securities Regulation, 84 Fordham L. Rev. 977 (2015).

[16] For a discussion on the benefits of crowdfunding for small investors, see Andrew Schwartz, Inclusive Crowdfunding, 4 Utah L. Rev. 661 (2016).

[17] Crowdfunding, 17 C.F.R. §§ 200, 227, 232, 239, 240, 249, 269, 274 (2015).

[18] See generally Fin. Conduct Auth., The FCA’s Regulatory Approach to Crowdfunding Over the Internet, and the Promotion of Non-Readily Realisable Securities by Other Media Feedback to CP13/13 and Final Rules (2014), https://www.fca.org.uk/publication/policy/ps14-04.pdf.

[19] See Loi 2014-559 du 30 mai 2014 relative au financement participatif [Law 2014-559 of May 30, 2014 relating to the crowdfunding], Journal Officiel De La République Française [J.O.] [Official Gazette of France], May 31, 2014, p. 9075.

[20] See Financial Markets Conduct Act 2013, subs 7 (N.Z.); Financial Markets Conduct Regulations 2014, reg 184 (N.Z.).

[21]  Kleinanlegerschutzgesetz [Retail Investor Protection Act], July 9, 2015, BGBl I at 1115 (Ger.).

[22] See Multilateral Instrument Crowdfunding, O. Reg. 45/108 (Can.); Start-Up Crowdfunding Registration and Prospectus Exemptions, N.B. Reg. 45/506 (Can.).

[23] See Corporations Amendment (Crowd-Sourced Funding) Act 2017 (Cth) sch 1 (Austl.).

[24] See OECD, Financing SMEs and Entrepreneurs 2016: An OECD Scoreboard 65 (2017), http://www.keepeek.com/Digital-Asset-Management/oecd/industry-and-services/financing-smes-and-entrepreneurs-2017_fin_sme_ent-2017-en#.WgJhG1ynET8.

[25] See Robert Wardrop et al., Breaking New Ground: The Americas Alternative Finance Benchmarking Report 19 (2016).

[26] See U.S. Sec. Exch. Comm’n, Recommendation Regarding Separate U.S. Equity Market for Securities of Small and Emerging Companies (Feb. 1, 2013), https://www.sec.gov/info/smallbus/acsec/acsec-recommendation-032113-emerg-co-ltr.pdf. However, the SEC only recommended that accredited investors be allowed to trade on this market or markets. Id.

[27] See Daniel M. Gallagher, Comm’r, U.S. Sec. Exch. Comm’n, Remarks at FIA Futures and Options Expo (Nov. 6, 2013), https://www.sec.gov/news/speech/2013-spch110613dmg; Kara M. Stein, Comm’r, U.S. Sec. Exch. Comm’n, Supporting Innovation through the Commission’s Mission to Facilitate Capital Formation (Mar. 5, 2015), https://www.sec.gov/news/speech/innovation-through-facilitating-capital-formation.html. For an example of such a proposed regional exchange, see, e.g., Haw. Dep’t Com. & Consumer Aff., Hawaii Exchange for Local Investment: Report to the Twenty-Sixth Legislature (Feb. 2012), http://files.hawaii.gov/dcca/dfi/reports
/Final-Report-Hawaii-Exchange-for-Local-Investment-Pursuant-to-SCR-134-SD1.pdf.

[28] For example, in Australia, the legislation introducing crowdfunding anticipated that secondary markets for crowdfunding would be established and provides the Minister with great flexibility for granting exemptions for such markets. See Corporations Amendment (Crowd-sourced Funding) Act 2017 (Cth) sch 3 (Austl.).

[29] Calida Smylie, NXT market launches today, Nat’l Bus. Rev. (June 18, 2015), https://www.nbr.co.nz/
article/nxt-market-launches-today-cs-174300.

[30] NZX’s Alternative Market Trading Dwindles, Scoop Bus. (Oct. 5, 2010), http://www.scoop.co.nz/
stories/BU1010/S00095/nzxs-alternative-market-trading-dwindles.htm.

[31] See Smylie, supra note 29.

[32] Important Information – Please Read Before Proceeding, Unlisted, http://www.unlisted.co.nz:80/
uPublic/unlisted.mt_public.home (last visited Nov. 6, 2017).

[33] Market Places, Armillary Private Capital, https://www.armillary.co.nz/Market-Places (last visited Nov. 6, 2017); see also James Murray, Equity Crowdfunding and Peer-to-Peer Lending in New Zealand: The First Year, JASSA Finsia J. Applied Fin. 2 (2015), http://www.finsia.com/docs/default-source/jassa-new/jassa-2015/jassa-2015-issue-3/equity-crowdfunding-and-p2p-lending-in-new-zealand-the-first-year.pdf?sfvrsn=8fcd9793_4.

[34] Jung Min-hee, Private Market for Startups KRX to Establish Private Market to Support Startups’ Stock Trading Before IPO, Business Korea (Mar. 24, 2016, 11:30 AM), http://businesskorea.co.kr/english/
news/smestartups/14199-private-market-startups-krx-establish-private-market-support-startups%E2%80%99-stock.

[35] Id.

[36] See Introduction, Taipei Exchange, Gofunding Zone, http://gofunding.tpex.org.tw/introduction.php?l=en-us&t=0  (last visited Nov. 6, 2017).

[37]AIM 20 – The World’s Most Successful Growth Market, London Stock Exchange, http://www.londonstockexchange.com/companies-and-advisors/aim/aim/aim.htm (last visited Nov. 6, 2017); Richard Wheat, The Death of Aim: Can Equity Crowdfunding Eclipse the LSE’s Junior Market? (Apr. 28, 2016, 4:42 AM),  http://www.cityam.com/239865/the-death-of-aim-can-equity-crowdfunding-eclipse-the-lses-junior-market; see also Susanne Espenlaub & Arif Khurshed, Is AIM A Casino? A Study of the Survival of New Listings on the UK Alternative Investment Market (AIM), Research Gate 4 (Dec. 2010), https://www.researchgate.net/publication/
228380249_Is_AIM_A_Casino_A_study_of_the_survival_of_new_listings_on_the_UK_Alternative_Investment_Market_AIM.

[38] Darryl Levitt & Andrew Derksen, The AIM listing Process: Steps to a Successful AIM Listing, Fasken Martineau, http://www.fasken.com/files/Publication/84c66c81-421b-47cd-bbfe-74eccafa86d5/Presentation/Public
ationAttachment/5b5d87c4-07fe-44e0-b03e-9bf76acd6073/AIM_LISTING_PROCESS.PDF (last visited Nov. 6, 2017).

[39] OTC Bulletin Board (OTCBB), FINRA, http://www.finra.org/industry/otcbb/otc-bulletin-board-otcbb (last visited Nov. 6, 2017).

[40] OTCQX, Investopedia, http://www.investopedia.com/terms/o/otcqx.asp (last visited Oct. 31, 2017). See generally Ulf Brüggemann et al., The Twilight Zone: OTC Regulatory Regimes and Market Quality,  Rev. Fin. Studies (2017).

[41] John Mackie, Delisting Deluge: Stocks Under Pressure And What To Do About It, SECNWS – Securities Law Newsletters (2009).

[42] Canada Securities Exchange, http://thecse.com/en/about (last visited Oct. 31, 2017).

[43] Christina Pellegrini, TMX Considers Change that Could Hamper Marijuana Industry, The Globe and Mail (Aug. 11, 2011), http://archive.li/m4YII#selection-6997.191-6997.199.

[44] David Johnston, Kathleen Rockwell & Cristie Ford, Canadian Securities Regulation 565­­­­­­­­­­­­–66 (5th ed., 2014).

[45] Eurogrowth, Euronext, https://www.euronext.com/en/listings/euronext-growth (last visited Oct. 31, 2017).

[46] Listing Q&A, Shenzhen Stock Exch., http://www.szse.cn/main/en/ListingatSZSE/ListingQA/ (last visited Oct. 31, 2017).

[47] Introduction, BSE, http://www.bseindia.com/static/about/introduction.aspx?expandable=0 (last visited Oct. 31, 2017).

[48] AIM Italia, London Stock Exch., http://www.lseg.com/areas-expertise/our-markets/borsa-italiana/equities-markets/raising-finance/aim-italia-mac (last visited Oct. 31, 2017).

[49] Overview, Japan Exch. Grp., http://www.jpx.co.jp/english/equities/products/tpm/outline/ (last updated Jan. 16, 2017)

[50] See e.g., Reena Aggarwal & James Angel, The Rise and Fall of the Amex Emerging Company Marketplace, 52 J. Fin. Econ., 257, 259–265 (1999) (describing the history of the failed Amex Emerging Company Marketplace).

[51] Id. at 264.

[52] For the profitability of pump and dump schemes, see Taoufik Bouraoui, Does ‘Pump and Dump’ Affect Stock Markets?, Int’l. J. Trade, Econ. & Fin., 45, 48 (2015).

[53] BaFin, Annual Report 2011, 195 (2012) .

[54] In 2005, BaFin reported that 55% of manipulation investigations were related to sham trading. See BaFin, Annual Report 2005, 158 (2006). These were transactions which are referred to as “matched orders,” prearranged transactions between two entities, or were “wash sales,” trades without changes in the beneficial ownership of the securities. Id. Another quarter of manipulation investigations were related to informational offenses, that is, misleading or incorrect information or the concealing of information. Id. It also reported that the transactions mainly impacted “illiquid equities or ‘penny stocks’ traded on the OTC market.”Id. In 2006, BaFin reported that reports by investors in relation to market manipulation doubled and “related primarily to low-liquidity financial markets traded in the OTC market.” See BaFin, Annual Report 2006 163 (2007). In 2007, it recognized the involvement of foreign companies in such schemes, noting that this “occurs when shares, mostly of foreign companies in the commodity sector, are included in . . . OTC trade[s] [on] German stock exchanges.” BaFin, Annual Report 2007, 173–74 (2008). By 2008, BaFin reported that “the significance of OTC trading for market manipulation remained consistently high” and that it was identifying “increasing levels of cross border manipulation in the German market.” BaFin, Annual Report 2008, 156, 162 (2009). In 2009, BaFin reported that “there has been a marked shift in the focus of BaFin’s report analysis activities towards market manipulation. Sham actions, such as matched trades, were the focal point of these activities in 2009 . . . . The shift from insider trading to more market manipulation analyses is likely to be due to the fact that the current market environment makes it more difficult for potential insiders to exploit their insider information to their advantage.” See BaFin, Annual Report 2009, 171 (2010) (citation omitted).

[55] See BaFin, Annual Report 2010, 187­–89 (2011).

[56] Id. at 188 (“The regulated unofficial market is run by the stock exchanges, but does not count as exchange trading. It is used primarily to trade small and in some cases highly illiquid stocks that are frequently of foreign origin. The conditions to be met for companies to be included are extremely lax compared with the regulated market. There is no serious examination of the issuers, nor must the companies comply with any reporting obligations. Even companies in respect of which it is completely unclear whether they have, or are planning, operational business activities can be included in trading extremely easily and used for manipulative purposes. Although Deutsche Börse AG introduced stricter inclusion requirements in 2009, this has yet to have any noticeable effect.”).

[57] See Bafin Annual Report 2011, 195 (2012).

[58] Id. at 168, 195.

[59] See U.S. Sec. Exch. Comm’n, Annual Report 2010, 2011 SEC 160; see also U.S. Sec. Exch. Comm’n, Litigation Release Archive 2010 (2010), https://www.sec.gov/litigation/litreleases/litrelarchive/litarchive2010.shtml (reporting, in 2010, that the SEC took action in relation to seventeen cases of manipulation primarily involving pump and dump schemes in the OTC market).

[60] The SEC does this through its Microcap Fraud Working Group established in 2012. This group scrutinizes microcap stocks to identify dormant shell companies that could be used for potential fraud. U.S. Sec. Exch. Comm’n, Annual Report 2012, 2013 SEC 136; U.S. Sec. Exch. Comm’n, Annual Report 2013, 2014 SEC 137.

[61] U.S. Sec. Exch. Comm’n, Litigation Release No. 22389 (JunefFffbi 4, 2012), https://www.sec.gov/litigation/litreleases/2012/lr22389.htm.

[62] See, e.g., United States v. Harold Bailey Gallison II, No. 1:15-CR-00178-AJT (E.D. Va. filed June 24, 2015).

[63] See, e.g., Sarah O’Brien, Brokers, Firms Land on FINRA’s ‘Bad Guys’ List, CNBC (May 11, 2016), http://www.cnbc.com/2016/05/10/brokers-firms-land-on-finras-bad-guys-list.html.

[64] Litigation Release Archives 2015, U.S. Sec. Exch. Comm’n (last visited Nov. 6, 2017), https://www.sec.gov/litigation/litreleases/litrelarchive/litarchive2015.shtml.

[65] See, e.g., U.S. Sec. Exch. Comm’n, Litigation Release No. 19481 (Dec. 2, 2012), http://www.sec.gov/litigation/litreleases/lr19481.htm; Rockies Fund, Inc. v. SEC, 428 F.3d 1088 (2005); U.S. Sec. Exch. Comm’n, Litigation Release No. 22326 (Apr. 11, 2012), http://www.sec.gov/litigation/litreleases/
2012/lr22326.htm.

[66] A 2017 survey conducted by the World Federation of Exchanges in relation to SME Financing and Equity markets found that for companies “a well-established regulatory and supervisory framework” was the most critical factor to the success of a market for SMEs. For retail and institutional investors, this was the second most important factor, the first being a mechanism to support SMEs to prepare disclosure documents. These factors were more important than liquidity, research analysis, tax incentives and simplified disclosure documents. See World Fed’n of Exchs., supra note 12.

[67] See Int’l Org. of Sec. Comm’ns, Objectives and Principles of Securities Regulation (June 2010), http://www.iosco.org/library/pubdocs/pdf/IOSCOPD323.pdf.

[68] Supra Part III.

[69] Douglas Cumming & Yelin Zhang, Are Crowdfunding Platforms Active and Effective Intermediaries? 4­–5 (Dec. 9, 2016) (unpublished manuscript) (on file with author) (finding that due diligence by crowdfunding platforms is associated with a higher percentage of successful campaigns and larger amount of capital raised on platforms).

[70] Ben Turney, Does the London Stock Exchange Deserve its Licence to Regulate AIM, UK Investor Magazine 26–27 (July 2015).

[71] See Joseph Gerakos, Mark Lang & Mark Maffett, Post-Listing Performance and Private Sector Regulation: The Experience of London’s Alternative Investment Market, J. Acct. & Econ. 189, 212 (2013) (finding that companies listed on the AIM underperformed similar firms listed on the NASDAQ, the OTC Bulletin Board, and the LSE Main Market but that firms subject to high quality auditors and NOMADs performed better although still not as well as the firms listed on the other markets—one reason may be that there were only few disciplinary actions taken against AIM firms and NOMADs and, even in those cases, the penalties were low).

[72] See Jeff Schwartz, Venture Exchange Regulation: Listing Standards, Market Microstructure and Investor Protection 15–16 (Sep. 8, 2016) (unpublished manuscript) (on file with author).

[73] See id.; Press Release, U.S. Sec. Exch. Comm’n, SEC Approves Pilot to Assess Tick Size Impact for Smaller Companies (May 6, 2015), https://www.sec.gov/news/pressrelease/2015-82.html (stating that the SEC is currently conducting a tick size pilot program).

[74] See Gallagher, supra note 27.

[75] See generally Janet Austin, Unusual Trade or Market Manipulation? How Market Abuse is Detected by Securities Regulators, Trading Venues and Self-Regulatory Organizations, 1 J. Fin. Reg. 263 (2015) (explaining how insider trading and market manipulation are detected by securities regulators).

[76] See generally Utpal Bhattacharya & Hazem Daouk, The World Price of Insider Trading, 57 J. Fin. 75 (2002) (explaining the impact of enforcement); Laura Beny, Do Insider Trading Laws Matter? Some Preliminary Comparative Evidence, 7 Am. L. & Econ. Rev. 144 (2005).

[77] 2014 O.J. (L 173) 179; Regulation 596/2014 (EU).

[78] Austin, supra note 75.

[79] See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111–203, § 922(a), 121 Stat. 1841–49 (2010) (inserting a new § 21F into the Securities Exchange Act of 1934); OSC Policy 15-601 Whistleblower Program (Policy 15 – 601/2016) (Can.), http://www.osc.gov.on.ca/documents/en/Securities-Category1/20160714_15-601_policy-whistleblower-program.pdf.

[80] Implementation of the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934, 17 C.F.R. §§ 240, 249 (2011).

[81] See generally Janet Austin, IOSCO’s Multilateral Memorandum of Understanding Concerning Consultation, Cooperation and the Exchange of Information – A Model for International Regulatory Convergence, 23 Crim. L.F. 393 (2012).

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^{Leon Dalezman and Philip Lenertz†}

This Article examines decisions made by the Internal Revenue Service on whether to promulgate regulations pursuant to three different but related provisions of the Internal Revenue Code: sections 1259, 1260, and 871(m). This Article concludes that when there is a statutory imperative to regulate, the use of softer methods—methods other than issuing new regulations, such as creating listed transactions—has a negative effect on tax law, slowing its evolution. Further, this Article suggests that this detriment is not outweighed by the positive effect of issuing regulations—chilling aggressive transactions in the short term. While clear regulatory lines almost always invite new forms of tax planning, this Article argues that this is better than a regime where legitimate tax planners are unfairly faced with uncertainty and where enforcement against egregious abuse is often less than forthcoming.

I.               Introduction

The evolution of tax law occurs in starts and fits. While Congress, the Internal Revenue Service (IRS), and the courts all play a role, the private tax bar is pivotal in pushing the boundaries and spurring legal change, even more so than in many other areas of law. When new transactions emerge, the law adapts to counter tax planning that it views as overly aggressive. Many have lamented the fact that the IRS is outgunned,^[1] and that the traditional methods of regulating have sometimes given way to using uncertainty as a weapon,^[2] enlisting third parties to validate and report information,^[3] relying on non-tax legal friction to chill private tax innovation,^[4] and even adopting pro-taxpayer “customary deviations” from statutory imperatives when the task of enforcement seems unattainable.^[5]

Another soft-regulation tactic used by the IRS is creating listed transactions. Listed transactions are expressly authorized by the Internal Revenue Code (Code).^[6] Once a transaction is listed, taxpayers and tax planners face penalties if they do not report the transactions promptly to the IRS.^[7] Through notices that announce new listed transactions, the IRS can create uncertainty by requiring information reporting, which slows aggressive behavior without running the risk of bringing an action and creating bad precedent if it lost in court. As long as the lines remain obfuscated and there are information reporting requirements, the full negative effects of a listed tax strategy on revenue never materialize since most taxpayers will not engage in the practice once it is listed. While there is merit to this IRS strategy, it does come with a downside. Having fewer regulations and fewer actions brought under these regulations slows the pace at which the courts interact with the tax law, which leads to an overall slowing of the tax law’s evolution.

Some of the most important and complicated statutory provisions of the modern Code were created in direct response to court decisions, often overturning decisions where the result led to a bad policy.^[8] In other cases, the Code and the regulations have incorporated court decisions.^[9] These clarifications and changes to the tax law are then cited later by courts, leading to a beneficial cycle where effort from all three branches of government contribute to a robust and meaningful tax law.

However, there are also disadvantages to regulating. The promulgation of regulations by the IRS is often met with aggressive tax planners’ attempts to get around the new regulation.^[10] In fact, it was this fear that caused the IRS in 1983 to withdraw regulations that were proposed under § 385^[11] that provided a much-needed distinction between debt and equity.^[12] Despite the fact that § 385 was enacted in 1969 and called for the U.S. Department of the Treasury (Treasury) to proscribe such regulations as may be necessary to determine whether an interest in a corporation is to be treated as stock or debt,^[13] the IRS subsequently withdrew them on the grounds that the proposed regulations were too vague and opened up the possibility of taxpayer manipulation.^[14] Instead, for nearly fifty years since its enactment, the debt-equity distinction was shaped through case law.^[15] It was not until 2016 that the Treasury finally issued final regulations under § 385 that were more narrowly tailored to target specific taxpayer behavior, notably inversions and earnings stripping.^[16] Given this background, it is no wonder that the IRS sometimes shies away from regulating in favor of a softer approach to stopping aggressive planning.

However, when regulation is expressly called for by statute, the failure of the IRS to provide regulation can lead to taxpayer confusion and abusive transactions.^[17] This happened with § 385, and more recently, with two statutory provisions dealing with derivatives. These two provisions provide even more apt examples. The constructive sale rules of § 1259 and the constructive ownership rules of § 1260 are among those containing a statutory demand for clarifying regulations.^[18] This is noteworthy because, despite these demands, regulations have not been issued for either provision even as taxpayer abuses have been ongoing. Conversely, the dividend equivalent amount statute, § 871(m), is also concerned with the use of derivatives to avoid taxation, but it contains no similar call for regulation.^[19] However, detailed regulations have been issued for § 871(m) in response to very similar taxpayer behavior as in the §§ 1259 and 1260 contexts.^[20]

This Article examines these three statutory provisions—§§ 871(m), 1259, and 1260—in detail, and concludes that additional regulation is more fair to legitimate tax planners, better at policing aggressive tax avoidance transactions, and more beneficial to the evolution of tax law.

II.               The IRS’s Failure to Heed Section 1260’s Call to Regulate Led to Hedge Fund Abuses

The IRS’s response to “basket options” and the failure of § 1260 to evolve provide examples of how government inaction creates uncertainty, which, in the case of § 1260, directly led to the loss of over six billion dollars in tax revenue.^[21] Congress enacted § 1260 in the 1990s in response to investors’ attempts “to use derivatives, including options on hedge funds, to convert short-term trading profits into long-term capital gains subject to a lower tax rate.”^[22] Section 1260 attacked these derivative-trading transactions by considering the owner of the derivative to be the “constructive owner” of the underlying security.^[23] However, while this provision demonstrated congressional intent to stop the abusive use of derivatives,^[24] including options, its subprovisions were drawn narrowly to stop the problematic tax schemes then under scrutiny and have not since been expanded by regulation to capture similarly abusive structures despite being statutorily authorized to do so.^[25]

An example of such a transaction that failed to fall within the grasp of § 1260 is the “basket option” transaction. In a basic basket option structure, a hedge fund client enters into a contract with a bank to purchase an option on the performance of an unspecified basket of assets placed in a designated account.^[26] The referenced account and all the securities are held in the name of the bank. The hedge fund provides a small percentage of the funds (for example, ten percent) to purchase the securities in the form of a premium on the option, and the bank provides the rest of the funds, with the hedge fund paying the bank fees for that amount. Despite the bank controlling the designated account, in most cases the bank appoints someone related to the hedge fund as an investment advisor who makes all the trading decisions. As a way for the bank to protect its downside, most of these option contracts contain a “knockout” provision, whereby if the designated account loses more than the amount of the hedge fund’s premium, the option contract would terminate. In most cases after a year, assuming the option did not terminate, the hedge fund will exercise its option at a strike price of the initial value of the securities in the basket and in return receive a cash settlement equal to the greater of zero or the reimbursement of the premium plus basket gain or less basket loss. The result of these transactions is to turn what would be short-term capital gains, due to the frequent trades the designated account engaged in, into long-term capital gains in the form of the gain from the option contract.

Given that this transaction does not fall cleanly within § 1260, the Treasury tried to police this behavior through non-binding notices and memoranda. In 2010, the IRS issued a General Legal Advice Memoranda (GLAM) arguing that the hedge fund taxpayer should be considered to “constructively own” the underlying securities.^[27] In 2015, the IRS issued a notice stating that basket option transactions are to be considered listed transactions and thus subject to reporting requirements.^[28] However, this proved to be ineffective^[29] since GLAMs are non-binding and the notice as written seems to allow taxpayers to structure transactions in a manner that avoids the narrow confines of the listed transaction as described.^[30]

The government’s final method of dealing with this type of transaction was to initiate a Senate investigation that culminated with the U.S. Senate Permanent Subcommittee on Investigations and the Committee on Homeland Security and Governmental Affairs issuing a report recommending that the IRS collect additional taxes from two hedge funds that engaged in transactions involving basket option structures.^[31] In reaching its conclusion, the report relies on § 1260, judicial doctrines such as the substance over form doctrine and the step transaction doctrine, and the 2010 GLAM.^[32]

Despite the fact that the government has devoted substantial resources investigating the two hedge funds and creating the report, and despite the fact that the cited transactions alone cost the government over 6.8 billion dollars of potential tax revenue,^[33] the IRS has not initiated any action against either of these hedge funds. This is likely because the IRS believes it will lose in litigation, given the lack of any clear statutory authority disallowing these transactions, resulting in pro-taxpayer precedent.^[34]

None of the rationales provided in the subcommittee report make it likely that a court would rule in favor of the IRS. As mentioned above, and laid out in the report, § 1260, despite giving the IRS authority to issue regulations on the matter, does not directly cover the case of basket options.^[35] While the GLAM and subcommittee report recharacterize the transaction as one where the hedge fund option holder is bearing all the risk, the reality is that the bank does bear some downside risk if all the money put into the basket by the bank is lost before the bank has the chance to sell the securities in the basket.^[36]

The judicial doctrine of substance over form would also not likely provide the IRS with a winning argument against a hedge fund using basket options. Despite its seemingly straightforward application to basket options, courts often do not rely on substance over form if a transaction seems authorized and there are no regulations disallowing it.^[37]

The net result is that, despite the notices and reports, the government does not have an actual way, short of regulations, to stop aggressive tax planners that are trying to take advantage of the ambiguity. Those that are trying to follow the law are left confused by what is and is not allowed. For example, the confusion surrounding what exactly falls under the “listed transaction” described in the notices causes risk-averse tax planners to be overly cautious. On the other hand, tax planners that have a lot to gain through aggressive tax planning, for example hedge funds, are inclined to take risks knowing well that there is little that the government will do after the fact other than issue a non-binding GLAM or report. Even if it is clear that a particular transaction falls within the description in an IRS notice, a taxpayer can avoid penalties under the regulations if contrary authority creates uncertainty about the viability of the government’s position.^[38] The result is that the current method of inaction by the IRS hurts tax planners trying to follow the law and helps those seeking to avoid it.

III.               The IRS’s Failure to Regulate under Section 1259 Left Holes in the Fight Against Constructive Sales and Set Confusing Precedent in the Courts

Section 1259 provides another example of how a law designed to halt the abusive use of derivatives to avoid taxation has suffered from the lack of government clarification after its enactment. Section 1259 requires a taxpayer who has a “constructive sale of an appreciated financial position” to “recognize gain as if such position were sold, assigned, or otherwise terminated at its fair market value on the date of such constructive sale.”^[39]

This statute was enacted in response to the Estee Lauder short sale against the box transaction where the founder of the company was able to get cash without paying tax by borrowing shares and shorting them while still holding a huge quantity of low basis shares from the founding of the company.^[40] As long as the short remained open, no tax could be levied since the extent of gain or loss on that transaction was uncertain; but what was certain was that however much the short gained or lost, the corresponding long position would cancel it out. This minimization of economic exposure to an asset without tax is now known as a constructive sale. Section 1259(c) describes what specifically qualifies as entering a constructive sale of an appreciated financial position and, like §1260, calls for regulations barring transactions with “substantially the same effect.”^[41] However, despite this, no regulations have yet been prescribed.

Even less guidance has been given for § 1259 than for § 1260. The only major preemptive guidance from the IRS has been revenue ruling 2003-7, which states that a transaction does not count as a constructive sale when, in exchange for payment, a taxpayer agrees to transfer at a fixed date 100 shares of stock if the price per share is under $20, a number of shares worth exactly $2,000 if the price per share is between $20 and $25, and 80 shares if the price per share is greater than $25.^[42] While this provides some guidance, it does not discuss the stock’s price volatility at all, instead relying on legislative history that merely states that “a forward contract that provides for the delivery of an amount of stock that is subject to ‘significant variation’ under the terms of the contract is not within the statutory definition of a forward contract.”^[43]

Both price volatility and the range of prices to which the counterparty has no economic exposure are important to a transaction like this. For example, if the price of the underlying stock in the revenue ruling had been fixed at, for instance, $22.50 for the last 10 years and had never fluctuated more than a dollar either up or down, then the transaction would look a lot more like a constructive sale for a fixed price of $2,000. Even though on paper there was “significant variation,” without examining price volatility such a forward is just as likely to be “for delivery of a substantially fixed amount of property [at] a substantially fixed price.”^[44]

The only other major development concerning how § 1259 is interpreted has been the single notable case where the IRS attempted to stop an end run around these rules, Anschutz v. Commissioner.^[45] In Anschutz, the taxpayer used a Prepaid Variable Forward Contract (PVFC) to receive money in exchange for a promise to deliver a variable number of shares of a corporation’s stock at some time in the future.^[46] By careful financial engineering, the product allowed the taxpayer to bear none of the downside risk below a set threshold while capping his upside exposure at a level only slightly higher.^[47] By limiting the exposure Anschutz had to such a narrow band, this arguably could have been caught by § 1259 had regulations been in effect. Without any, the court held that the transaction was not a constructive sale, relying on revenue ruling 2003-7’s statement that a forward for a variable number of shares between 80 and 100 was not a constructive sale.^[48]

Curiously, the court ruled in favor of the Commissioner overall on the basis of an actual sale theory under § 1001 due to a simultaneous pledge agreement where the counterparty to the PVFC got to control the stock immediately.^[49] While the facts of the case suggest that this was the right result under § 1001, it raises the question of how something could be an actual sale yet fall short of the constructive sale threshold, given that a constructive sale is supposed to be something less than an actual sale. The court may have struggled with this apparent inconsistency too, stating in its opinion that its decision on the constructive sale issue might have come out differently had regulations been issued outlining in more detail what counted as a constructive sale.^[50]

Of course, had the IRS issued regulations beforehand, then tax planners may have side-stepped them in a different way than was attempted in Anschutz. Any time a bright-line rule is advanced, it increases the ability of planners to create transactions that fall just barely on the right side of the line while still getting their desired tax advantages. But the court decision in Anschutz created the same result: now that there is precedent that a certain technique is not a constructive sale, it is more likely to be used by others going forward. Had regulations been in place, the court might have considered the Anschutz transaction a constructive sale. Even if it did not, having both the court opinion and the regulations would make it easier for the legislature to change the law going forward if Congress decides that the transaction should have counted as a constructive sale.

IV.               Despite their Imperfections, Regulations Issued under Section 871(m) Provide a Framework that Could Benefit Sections 1260 and 1259

Derivatives have also been used to avoid § 871(m), which provides for a tax on U.S. source dividend equivalent amounts received by nonresidents.^[51] U.S. source dividends themselves are taxed as Fixed, Determinable, Annual, or Periodical (FDAP) income when nonresidents receive them from U.S. sources at a 30% withholding rate.^[52] Prior to § 871(m), however, a nonresident could get the exact same economic payout and avoid withholding on dividends by buying a derivative instead of the stock itself.^[53] Such a derivative would appreciate in line with the stock and give the holder gain equal to the amounts of dividends paid out as well. Then, when the derivative was sold outside the U.S., the gain from sale would be foreign source income, thus avoiding the dividend withholding tax completely.

As with §§ 1259 and 1260, § 871(m) is concerned with the use of derivatives to escape taxation.^[54] What is odd is that despite no statutory language inviting clarifying regulations, in the § 871(m) context the IRS has in fact regulated.^[55] Notably, for the first time in its history, the IRS has used the financial measurement of delta to write rules governing whether or not a transaction is in substance barred by the statute.^[56] However, the problem with these regulations is that they are sometimes unclear, and scholars have questioned the accuracy of the mathematics.^[57] The definition of delta in the regulations is correct, but an extra step appears to be added that could cause distortions in the result.^[58] Nevertheless, with these regulations in place, changes could be made to remedy these problems and improve the manner in which financial engineering of derivatives that too closely mirror the payout of stock ownership is restricted.

Issuing the § 871(m) regulations was sensible, but it raises the question of why the IRS would develop a regulatory tool only in this context and not employ it in others that involve essentially similar uses of derivatives like §§ 1259 and 1260. Here, perhaps the answer is that the IRS chose to regulate instead of creating listed transactions or relying on a revenue ruling because it is harder to get information reporting from nonresidents. Or it could be that § 1259 just addresses a less common situation, so the bottom line effect on revenue might be thought not to justify the time and effort of regulation. In Anschutz, that the taxpayer had just elected to become an S corporation was significant to its motivation, and the taxpayer would have had to pay corporate tax if it recognized any built-in gain on the corporate assets within 10 years after the S corporation election.^[59] But, the benefit of immediate money without taxation on an appreciated asset seems ripe for abuse in all manner of other situations too. And such an explanation does not hold at all for § 1260, which is all that stands in the way of huge tax savings by any hedge fund. It seems therefore that there is nothing special that makes § 871(m) more likely to be avoided by aggressive tax planning.

V.               Conclusion

Issuing regulations to improve and clarify the Code wherever it is ambiguous would be a difficult task. There is, of course, an alternate approach: comprehensive tax reform. If many of the current distinctions between formally different but economically similar forms of income or expense were removed, much tax avoidance strategy would no longer be effective.^[60] A mark-to-market regime would also fix many of these problems; although, it would create others.^[61] These approaches, though, require unified action from Congress and a consensus on what the goals of the tax law should be. Unfortunately, such sweeping changes do not seem likely to come any time soon, especially not without intervening events that expose more clearly the weaknesses of the current system.

Thus, clear ex ante regulations are needed; implementing something less, like a general anti-abuse regulation, will have the same effect on taxpayers as any other soft mechanism for stopping abuse in that it will still create uncertainty and still not deter the most aggressive tax planners.^[62] It is possible to point to the problems in the § 871(m) regulations as evidence that when the IRS tries to use its regulatory authority, it is as likely to get things wrong as it is to get them right. But this overlooks the fact that the law can only develop when it is subjected to testing by private-party tax innovation. And even though bad regulations in full view of the legal community like the § 871(m) regulations invite tax planning, having a clear line is still better than the uncertainty prevalent in other areas of tax law such as §§ 1259 and 1260 where legitimate tax planners are potentially at risk of being caught up in an ill-defined net cast someday in the future should the IRS decide to change its approach and bring litigation.

Further, even short of comprehensive congressional tax reform, to amend an existing regulation is easier than to write one from scratch, and blatant mistakes that create loopholes are those most likely to be remedied. This is especially true when Congress has given clear statutory authority to regulate substantially similar transactions. To decline that invitation is counterproductive and leads to courts attempting to craft decisions in the face of terms without definitions, like the court in Anschutz. The IRS’s crutch of relying on other methods such as listed transactions, notices, revenue rulings, and reports hurts everyone due to the lack of guidance. While issuing regulations in response to particular transactions will result in some aggressive tax planners finding new ways to circumvent them, it would at least guarantee a stop to the particular action that caused its implementation, invite legitimate transactions to occur, and allow the legal landscape of tax law to evolve.

† Leon Dalezman and Philip Lenertz are J.D. Candidates at Harvard Law School (2017). The Authors would like to thank Professor Thomas J. Brennan, the Stanley S. Surrey Professor of Law at Harvard Law School, for helpful discussions and commentary while developing the article.

[1] See David M. Schizer, Enlisting the Tax Bar, 59 Tax L. Rev. 331, 334­–36 (2006). See generally Alex Raskolnikov, Crime and Punishment in Taxation: Deceit, Deterrence, and the Self-Adjusting Penalty, 106 Colum. L. Rev. 569, 583–84 (2006).

[2] See Leigh Osofsky, The Case Against Strategic Tax Law Uncertainty, 64 Tax L. Rev. 489, 538 (2011).

[3] See Leandra Lederman, Statutory Speed Bumps: The Roles Third Parties Play in Tax Compliance, 60 Stan. L. Rev. 695, 742–43 (2007).

[4] David M. Schizer, Frictions as a Constraint on Tax Planning, 101 Colum. L. Rev. 1312, 1323–24 (2001).

[5] See generally Lawrence Zelenak, Custom and the Rule of Law in the Administration of the Income Tax, 62 Duke L.J. 829 (2012) (suggesting that the IRS’s treatment of frequent flyer miles earned by business travelers is an example of a “customary deviation”).

[6] I.R.C. § 6707A (2012) (prescribing penalties for failure to report listed transactions); Treas. Reg. § 1.6011-4 (2017) (“Requirement of statement disclosing participation in certain transactions by taxpayers”).

[7] I.R.C. § 6707A (2012).

[8] See, e.g., I.R.C. § 311 (2012) (supplanting the holding and subsequent codification of Gen. Utils. & Operating Co. v. Comm’r, 296 U.S. 200 (1935)); I.R.C. § 355(e) (2012) (penalizing specific kinds of spin-off transactions that had been allowed by the courts in Esmark, Inc. & Affiliated Cos. v. Comm’r, 90 T.C. 171 (1988)).

[9] See, e.g., Treas. Reg. § 1.338(h)(10)-1(d)(5) (2017) (incorporating the facts and holding of Kass v. Comm’r, 16 T.C.M. 1035 (1957), into an example of how the continuity of interest doctrine can apply unfavorably to minority shareholders in a reorganization).

[10] See George K. Yin, Getting Serious About Corporate Tax Shelters: Taking a Lesson from History, 54 SMU L. Rev. 209, 215–18 (2001) (referring to the incremental changes in law in response to tax shelters as the “tax avoidance game”).

[11] I.R.C. § 385 (2012).

[12] See 48 Fed. Reg. 50711 (Nov. 3, 1983); see also Jeffrey D. Eicher & Leo N. Hitt, Section 385: Debt by Any Other Name . . ., 65 Tax Notes 1033 (1994); Thomas A. Humphreys et al., Morrison & Foerster, LLP, Proposed IRS Debt-Equity Regulations: Aimed at Post-Inversion “Earnings Stripping,” But May Also Impact Ordinary Related-Party Debt 1–8 (2016), https://media2.mofo.com/documents/160412irsdebtequity
regulations.pdf.

[13] See I.R.C. § 385(b).

[14] See Humphreys et al., supra note 11, at 2.

[15] See Treatment of Certain Interests in Corporations as Stock or Indebtedness, 81 Fed. Reg. 20,912, 20,913–14 (Apr. 8, 2016) (to be codified at 26 C.F.R. pt. 1).

[16] See Trey Whitten et al., The Final and Temporary Section 385 Regulations: Scope and Recharacterization Rule, 44 J. Corp. Tax’n 18, 18–19, 22 (2017).

[17] Courts’ interactions with tax statutes in these circumstances has been quite varied. A test has arisen that  distinguishes between when delegation of rulemaking to the IRS concerns “whether” a policy is to be effective for a certain class of taxpayers or if instead the delegation is merely to determine “how” a statutory policy is to be administered. In the former circumstance, judges treat the absence of regulations as a decision that the policy does not apply, since the absence of regulations could plausibly mean that the IRS does not wish the policy to apply. In the latter circumstance, judges generally have leeway to interpret statutes as though hypothetical “phantom” regulations had been issued, while still acknowledging that if the IRS ever issued actual regulations, they might differ from those of the judge. See generally Phillip Gall, Phantom Tax Regulations: The Curse of Spurned Delegations, 56 Tax L. 413 (2003).

[18] See I.R.C. §§ 1259, 1260 (2012).

[19] See I.R.C. § 871(m) (2012).

[20] See 26 C.F.R. § 1.871-15 (2017).

[21] See Majority and Minority Staff of U.S. S. Permanent Subcomm. on Investigations, Abuse of Structured Financial Products: Misusing Basket Options to Avoid Taxes and Leverage Limits, at 5, 74 (2014), https://www.hsgac.senate.gov/subcommittees/investigations/hearings/abuse-of-structured-financial-products
_misusing-basket-options-to-avoid-taxes-and-leverage-limits [hereinafter Senate Report].

[22] Id. at 20.

[23] See I.R.C. § 1260(d) (2012).

[24] See H.R. Rep. No. 106-478, at 159–60 (1999) (Conf. Rep.).

[25] See I.R.C. § 1260(d)(1)(D). No regulations have been promulgated under I.R.C. § 1260(d)(1)(D).

[26] See I.R.S. Gen. Couns. Mem. AM2010-005, at 2–3 (Nov. 12, 2010); Senate Report, supra note 21, at 13–16.

[27] See I.R.S. Gen. Couns. Mem. AM2010-005, at 1–2, 10.

[28] See I.R.S. Notice 2015-73, 2015-46 I.R.B. 660; see also I.R.S. Notice 2015-74, 2015-46 I.R.B. 663.

[29] See Senate Report, supra note 21, at 5–6.

[30] See I.R.S. Notice 2015-73, 2015-46 I.R.B. 660; see also I.R.S. Notice 2015-74, 2015-46 I.R.B. 663. A taxpayer can specifically alter the structure of a transaction in order to get around the definition of “discretion” and “designee” by, for example, leasing the trading algorithm software to a separate joint venture created with the bank and hedge fund.

[31] See Senate Report, supra note 21, at 7.

[32] Id. at 20–25.

[33] Id. at 5.

[34] See, e.g., infra text accompanying notes 45–50 (discussing how the Anschutz case led to bad precedent being set).

[35] See Senate Report, supra note 21, at 22.

[36] See id. at 3–4, 42. “Gap risk” refers to the risk borne by the bank where market conditions deteriorate so rapidly that all the premiums paid by the hedge fund are lost and the bank is unable to sell the remaining assets quickly enough to cover losses in excess of the premium.

[37] See, e.g., Summa Holdings, Inc. v. Comm’r, 848 F.3d 779, 782 (6th Cir. 2017) (holding that the substance over form doctrine is inapplicable since “‘[f]orm’ is ‘substance’ when it comes to law”) (emphasis in original); Granite Trust Co. v. United States, 238 F.2d 670, 677–78 (1st Cir. 1956).   

[38] See Treas. Reg. § 1.6662-3(b)(2) (2017); Osofsky, supra note 2, at 509.

[39] I.R.C. § 1259 (2012).

[40] Floyd Norris, New Tax Law Takes Aim at Estee Lauder, N.Y. Times (Aug. 6, 1997), http://www.nytimes.com/1997/08/06/business/new-tax-law-takes-aim-at-estee-lauder.html.

[41] See I.R.C. § 1259(c)(1) (“A taxpayer shall be treated as having made a constructive sale of an appreciated financial position if the taxpayer (or a related person)–(A) enters into a short sale of the same or substantially identical property, (B) enters into an offsetting notional principal contract with respect to the same or substantially identical property, (C) enters into a futures or forward contract to deliver the same or substantially identical property, (D) in the case of an appreciated financial position that is a short sale or a contract described in subparagraph (B) or (C) with respect to any property, acquires the same or substantially identical property, or (E) to the extent prescribed by the Secretary in regulations, enters into 1 or more other transactions (or acquires 1 or more positions) that have substantially the same effect as a transaction described in any of the preceding subparagraphs.”).

[42] Rev. Rul. 2003-7, 2003-1 C.B. 363, 2003-5 I.R.B. 363.

[43] Id. (citing S. Rep. No. 33, at 125–26 (1997)).

[44] S. Rep. No. 105-33, at 125–26 (1997), as reprinted in 1997 U.S.C.C.A.N. 1067, 1205–06.

[45] Anschutz Co. v. Comm’r, 135 T.C. 78 (2010), aff’d, 664 F.3d 313 (10th Cir. 2011).

[46] Id. at 81–82.

[47] Id. at 87.

[48] Id. at 111–13.

[49] Id. at 104.

[50] Id. at 111–12 (“Section 1259 does not define the terms ‘substantially fixed amount of property’ or ‘substantially fixed price[.]’ Section 1259 gives the Secretary two sources of authority for issuing regulations to carry out Congress’ intent—section 1259(c)(1)(E) and (f)–but no regulations have been issued defining either phrase.”).

[51] See Report on Proposed Regulations under Section 871(m), 2014 N.Y. St. Bar Ass’n, Tax Sec. Rep. 1340.

[52] I.R.C. § 871(a)(1) (2012).

[53] See Report on Proposed Regulations under Section 871(m), 2014 N.Y. St. Bar Ass’n, Tax Sec. Rep. 1340.

[54] I.R.C. § 871(m).

[55] Treas. Reg. § 1.871-15 (2017).

[56] Delta measures the degree to which the rate of change in the price of a derivative mirrors the rate of change in the price of the underlying asset it refers to. A delta of 1 means that the price of the derivative and the asset move together in uniformity.

[57] Thomas J. Brennan & Robert L. McDonald, The Problematic Delta Test for Dividend Equivalents, 146 Tax Notes 525 (2015).

[58] Id.

[59] I.R.C. § 1374(a) (2012).

[60] See, e.g., Noel B. Cunningham & Deborah H. Schenk, The Case for a Capital Gains Preference, 48 Tax L. Rev. 319 (1993) (addressing the reasons for the long-term capital gains preference); Michael J. Graetz & Alvin C. Warren, Jr., Integration of Corporate and Shareholder Taxes, 69 Nat’l Tax J. 677 (2016) (proposing a system that would remove many of the distortions caused by the current double taxation of corporate earnings); Matthew T. Schippers, The Debt Versus Equity Debacle: A Proposal for Federal Tax Treatment of Corporate Cash Advances, 64 U. Kan. L. Rev. 527, 570–71 (2015) (discussing the treatment of debt versus equity prior to the 2017 § 385 regulations targeting inversions).

[61] See, e.g., David A. Weisbach, A Partial Mark-to-Market Tax System, 53 Tax L. Rev. 95, 135 (1999).

[62] See Yin, supra note 10, at 210, 230 (arguing that the uncertainty of an anti-abuse rule will likely undermine its ability to be an effective deterrent to corporate tax shelters).

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^{Cody Donald†}

I.               Introduction

A trade in a substitute security occurs when a trader with inside information, typically an employee, trades—not in the securities of the company that is the subject and source of the information—but in the securities of another company whose stock would be affected if such inside information were to become public. The main piece of academic literature on this topic is Ian Ayres and Joe Bankman’s article, Substitutes for Insider Trading.^[1] This Article builds on that work by providing a more in-depth analysis of liability for insider trading on substitute securities under Rule 10b-5 promulgated under the Securities Exchange Act of 1934.^[2] In contrast to Ayres and Bankman,^[3] this Article concludes that trading in substitute securities is presumptively illegal under the misappropriation theory pursuant to Rule 10b-5. While Ayres and Bankman argue that a possible-harm standard may apply to trades in substitute securities, such a standard is supported by neither background state law nor federal precedent. Instead, a fiduciary-sourced default rule should apply, which requires only the use of confidential information for private benefit to establish liability. Moreover, even if the possible-harm standard were to apply, most trades in substitute securities could result in a possible harm to the source of the information by way of reputational damage.

II.               An Overview of Trading in Substitute Securities

In short, a trade in a substitute security occurs when an insider of one company (“A Corp.”) who has inside information about A Corp., beneficially trades not in the stock of A Corp., but in the stock of another company (“B Corp.”).^[4] This trade is advantaged because the inside information from A Corp. correlates to the performance of the stock of B Corp. There are four main types of companies that are likely to have stock prices that are correlated with any given company’s stock price: that company’s suppliers of goods or services, customers of goods or services, manufacturers or providers of competing goods or services (competitors), and manufacturers or providers of complimentary goods or services (complementors).^[5] Trading in substitute securities may be accomplished directly through the purchase or short sale of stock of a substitute company, indirectly by trading in derivatives of a substitute company, or in indexes of the industry generally.^[6]

The direction of correlation between two linked companies is dependent on the type of information. For example, when Kodak entered the instant camera market, the shares of Polaroid, the only extant competitor, fell by 12.7%.^[7] This negative correlation is the expected result of a zero-sum game between substitute products.^[8] However, if Kodak subsequently beat analyst estimates as a result of an increase in general market demand for instant cameras, the share price of both Kodak and Polaroid would also likely increase. This information provided by Kodak would be incorporated into the share price of both companies.^[9] Thus, Kodak and Polaroid may also be positively correlated, depending on the nature of the information.

The trading in substitute securities has the potential to achieve high, short-term returns. Ayres and Bankman analyzed a set of hypothetical substitute-security transactions, based on a 1998 Intel earnings announcement and the correlative effect on other companies and the Philadelphia Semiconductor Index.^[10] A substitute-security trade directly on shares of the index would allow the hypothetical Intel insider (or Intel itself) to achieve a 6.0% to 7.3% two-week return (354.2% to 523.5% annualized).^[11] In addition, a hypothetical set of option purchases in correlated companies would have produced a two-week return of 21.1% (14,277.5% annualized).^[12]

III.             Legality of Trading in Substitute Securities Under Rule 10b-5

A.             Employees and Other Insiders

The first and most common^[13] form of trading in substitute securities is trading by an employee or other insider of the source of the information. A brief set of scenarios will help guide the analysis in this section:

Scenario 1: X is an employee of A Corp. and is in possession of information indicating that A Corp. is getting ready to manufacture Widget M that directly competes with Widget N manufactured by B Corp. Using that information, X short sells the stock of B Corp. Subsequently, A Corp. announces that it is selling Widget M. The share price of A Corp. climbs while the share price of B Corp. falls. X makes a sizeable profit.

Scenario 2: Same facts as Scenario 1, except X buys the shares of a supplier, C Corp., with which A Corp. currently has a contract and expects to order a significant number of critical components to manufacture Widget M. On announcement, the share price of C Corp. rises significantly.

Scenario 3: Same facts as Scenario 2, except X buys a controlling interest in C Corp.

1.             Liability under the Traditional “Equal Access” Theory

Although explicitly overruled,^[14] the equal access theory derived from the Securities and Exchange Commission (SEC) administrative action Cady, Roberts & Co.^[15] is still useful to determine the theoretical and policy limitations of insider trading liability. While Cady, Roberts was narrowly considering the trading of the stock of the source company,^[16] it explicitly required only that there was a “relationship giving access, directly or indirectly, to information intended to be available only for a corporate purpose” and “the inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing.”^[17] The resulting fundamental premise of the theory is that “anyone in possession of material inside information must either disclose it to the investing public, or . . . must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed.”^[18]

Applying this theory to each of the scenarios above (and indeed the scenarios detailed below in Part III.B.3 as well), X could be found liable for trading in substitute securities. As a preliminary matter, the information on which the insider trades would be material under prevailing law^[19]: a reasonable investor in either the supplier or the competitor would likely consider information concerning A Corp.’s intention to enter the widgets industry as important in a potential transaction.^[20] Furthermore, X possesses the information only by virtue of his position as an insider and exploits that corporate information to the unfair disadvantage of the holders of the substitute security. Therefore, the failure to disclose the inside information to X’s counterparty would constitute a fraud under the equal access theory of Rule 10b-5.

Of course, the SEC would not be able to resort to this theory today.^[21] Nevertheless, it shows the potential outer limits of what the SEC may consider is, or should be, a violation of Rule 10b-5. Furthermore, it serves as a guidepost toward which the misappropriation theory appears to be headed.^[22]

2.             Liability under a “Classical” Fiduciary Duty Theory

The fiduciary duty theory originates in Chiarella v. United States.^[23] In that case, the defendant used information he gleaned from a hostile bidder to trade on the stock of the target firm. After overruling the equal access theory, the Court set a new standard for fraud under Rule 10b-5: “[w]hen an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak.”^[24] This duty to disclose must arise “from a relationship of trust and confidence between parties to a transaction.”^[25]

In application to the facts of Scenario 1, it appears likely that X cannot be found liable under the theory announced in Chiarella. There is no relationship between X and B Corp. or between X and the counterparty to the short sale. As such, X has no duty to disclose. The existence of a relationship of trust and confidence between A Corp. and the supplier in Scenarios 2 and 3 appears to invoke the temporary insider doctrine.^[26] However, in all scenarios, X obtained the confidential information through the fiduciary relationship with his employer, and not from any relationship with the supplier. Therefore, even if the corporate supply contract were to be attributed to X, it was not a breach of any relationship with the supplier to use the distinct corporate information for his own personal benefit.^[27] Consequently, the doctrine does not provide any additional support for the liability of X in either scenario.

3.             Liability under the Misappropriation Theory

In general, “[t]he ‘misappropriation theory’ hold[s] that a person commits fraud ‘in connection with’ a securities transaction, and thereby violates § 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.”^[28] In United States v. O’Hagan, the lawyer-defendant obtained information pertaining to that company’s tender offer and traded in the securities of the target firm.^[29] This violated the duties of confidentiality he owed to both his law firm and to the client with whom he was working.^[30]

In applying the misappropriation theory to trades in substitute securities, the primary question is whether X’s trading on a competitor’s stock, as in Scenario 1, is a breach of a duty owed by X to the source of the information, namely A Corp. Of course, if X’s employment contract were to explicitly allow or disallow trading in substitute securities, that would govern whether there was misappropriation.^[31] In the probable likelihood that there is no explicit contract provision,^[32] Ayres and Bankman lay out two theories that could govern default law: the fiduciary-sourced default rule and the possible-harm standard.^[33] In the fiduciary-sourced default rule, the insider can never trade without permission from the source of the information.^[34] If this rule is applied to these three scenarios, X would be liable for insider trading because he would have a duty to disclose to his employer or to abstain from using the corporate information for private benefit. In contrast, in the possible-harm standard, the insider would be prohibited from trading in substitute securities only when such trades are likely to cause harm to the source of the information.^[35]

However, the possible-harm standard is not supported by background state law on the fiduciary duty of loyalty, whereas the fiduciary-sourced default rule is well supported by precedent.^[36] Consequently, a fiduciary-sourced default rule should be applied to trading in substitute securities. Since trading in substitute securities necessarily involves the use of inside information for private benefit, it violates the insider’s duty of loyalty and runs afoul of Rule 10b-5. Moreover, even if the possible-harm standard did apply, many cases of trading in substitute securities may result in a possible harm because the corporation could possibly suffer reputational harm in current or future relationships.^[37] Therefore, trading in substitute securities is presumptively illegal under Rule 10b-5.

i.             The Fiduciary-Sourced Default Rule Should Apply

The content of the fiduciary duties under the misappropriation theory of Rule 10b-5 may be derived from three sources of background law: state agency law, state contract law, or federal common law. In each case, the possible-harm standard is not supported and the fiduciary-sourced default rule should be applied in its place.

The possible-harm standard is not supported by state law on the fiduciary duty of loyalty because state law does not require a harm to the principal in order for the agent to be liable. In general, “[a]n agent has a duty not to acquire a material benefit from a third party . . . through the agent’s use of the agent’s position.”^[38] To recover from the agent, “it is not necessary that the principal show that the agent’s acquisition of a material benefit harmed the principal.”^[39] The lack of a requirement for possible harm also draws support from early state law cases on insider trading: “[i]n equity, when the breach of a confidential relation by an employee is relied on and an accounting for any resulting profits is sought, loss to the corporation need not be charged in the complaint.”^[40] Thus, if the fiduciary duties under the misappropriation theory of Rule 10b-5 are derived from state law, there would be no requirement for a possible harm to the source of the confidential information.

Principally, Ayres and Bankman draw support for the possible-harm standard under a contract theory of implied terms: if the parties were to draft a contract, they would likely limit breaches of duty to situations in which the corporation was harmed.^[41] While this supposition may be generally supported from a business perspective, the employer’s and employee’s understanding of the relationship does not control the interpretation of rights and duties of the parties in that relationship.^[42] Typically, state law fiduciary duties apply by default and the employer-principal must explicitly consent to waive the duty of loyalty of the employee-agent with respect to a specific transaction or class of transactions.^[43] Thus, while employers might be able to waive the duty of loyalty conflict prospectively, where the employment contract is silent on the issue of trading in substitute securities, state law on fiduciary duties would apply. Since such state law does not require a possible harm to the principal, it seems probable that a court would not ordinarily imply consent to use or disclose information for personal benefit where no harm to the principal would result.

The final source of fiduciary duties under the misappropriation theory is from federal case law itself. Significantly, given that recent cases are generally silent on the source of the law governing such duties,^[44] perhaps the duty on which all insider trading is now based is not derivative of any state law claim but exists as an independent duty under federal common law.^[45] With respect to trading in substitute securities, it is notable that the primary cases involving misappropriation concern tender offers or other similar transactions.^[46] In these cases, such a trade risks an increase in the market price of the target firm, which directly harms the attempted acquisition or damages an outside firm’s reputation by breaching confidentiality.^[47]

However, in O’Hagan, the Court implicitly suggested that the fraud was completed with the harm on the counter-party to the transaction, irrespective of the harm to the source of the information:

The securities transaction and the breach of duty thus coincide. This is so even though the person or entity defrauded is not the other party to the trade, but is, instead, the source of the nonpublic information. [See Barbara B. Aldave, Misappropriation: A General Theory of Liability for Trading on Nonpublic Information, 13 Hofstra L. Rev. 101, 120 (1984) (“A fraud or deceit can be practiced on one person, with resultant harm to another person or group of persons . . . .”).] A misappropriator who trades on the basis of material, nonpublic information, in short, gains his advantageous market position through deception; he deceives the source of the information and simultaneously harms members of the investing public.^[48]

This suggests that the misappropriation theory requires only a breach of the duty of confidentiality and that whether harm is done to the source of the information is irrelevant.^[49] Therefore, the possible-harm standard is not applicable, and mere disclosure for a private benefit suffices—the fiduciary-sourced default.

Additionally, the case law regarding tippee liability supports the federal common law theory that does not require possible harm. In particular, the Supreme Court has defined an insider’s breach of duty as requiring only the disclosure of confidential corporate information for a personal benefit.^[50] It follows that if disclosing information for personal benefit would constitute an insider’s breach, then the insider directly using that inside information for a personal benefit would likewise constitute a breach of the insider’s duties.^[51] Such a duty does not, or at least does not explicitly, address the question of harm to the company and therefore would support the fiduciary-sourced default rule.

Overall, while the possible-harm standard may be a rational and justifiable private standard to limit the application of the misappropriation theory to trades in substitute securities, the standard appears to have weak justification in current case law on Rule 10b-5 as well as in agency law generally. Consequently, the fiduciary-sourced default rule is more likely to be applied to trading in substitute securities, and thus, under the misappropriation theory, an insider must always abstain from trading in substitute securities unless he discloses the matter to the source of the information. At least in this context, it appears that the conception of Rule 10b-5 liability has largely returned to the equal access theory—albeit that the target of the disclosure may not be a party to the transaction.

ii.             Trading in Substitute Securities May Cause Possible Harm to the Source of the Information

While the possible-harm standard is not supported by state or federal law, if it did apply to trading in substitute securities, it is feasible that every trade in substitute securities could result in a possible harm to the source of the information. In application to the scenarios laid out above, it appears likely that the corporation suffered no immediate or direct harm in Scenario 1, because A Corp. has no direct relationship with the party harmed by the trading in substitute securities. On the other hand, if the possible harm were reputational damage from the breach of confidentiality as indicated by Ayers and Bankman,^[52] then the similar breach of confidentiality by X in Scenario 1 would violate the possible-harm standard to the extent that it affected any future relationships with A Corp. It appears likely that at least in some circumstances, the mere private use of corporate information, even when trading in a completely unrelated company, may cause enough of a reputational damage that customers or suppliers would only be willing to engage with the source on less favorable terms. Essentially, A Corp. would be required to buy insurance against the possibility that its insiders would again use inside information to the detriment of shareholders. As much as a car accident will increase car insurance rates, incidences of trading in substitute securities will raise insider trading insurance rates. Since a literal reading of a possible-harm standard would include all possibilities, no matter how remote, and the trading in substitute securities could raise costs for the source of the information, the insider could be liable in Scenario 1 for trading in substitute securities.^[53]

In Scenario 2, there is a much higher risk that the transaction would affect the relationship between A Corp. and C Corp. There, the previous owners of C Corp. suffer a definitive harm, just as the previous owners of B Corp. suffered a definitive harm in Scenario 1. Unlike in Scenario 1, in Scenario 2, A Corp. and C Corp. have an ongoing relationship. Therefore, the possibility of reputational damage affecting relations, as discussed in application to Scenario 1, is likely to be less remote and hence has a higher risk of immediate harm. Moreover, there might be a retaliatory element as C Corp. may seek to directly recover or inflict harm on A Corp.

Scenario 3 presents a clearer example of a situation in which A Corp. is likely harmed by the trade in substitute securities, as the transaction more clearly seems to be a conversion of the corporate information, and the relationship between A Corp. and C Corp. is likely to be substantially altered, if not impaired. The reputational harms, as discussed in the application to Scenarios 1 and 2, are also possible in this case because X would not immediately control the board of C Corp., which might decide to alter relations with A Corp., possibly to A Corp.’s detriment. Moreover, X might subsequently use his inside knowledge to direct changes in the relationship between A Corp. and C Corp., which have at least the potential to harm A Corp. This is especially true where A Corp.’s information indicates reliance on C Corp. and C Corp.’s market power, or when, by virtue of X’s control, C Corp. waits to sign a long-term supply contract until after the product’s announcement. However, an issue with this directive theory is whether the fraud is “in connection with the purchase or sale of any security.” In Chadbourne & Parke LLP v. Troice, the Court stated, “[a] fraudulent misrepresentation or omission is not made ‘in connection with’ such a ‘purchase or sale of a covered security’ unless it is material to a decision by one or more individuals (other than the fraudster) to buy or to sell a ‘covered security.’”^[54] Arguably, the harm in directing the company could be considered disconnected from the omission in the securities transaction. However, the prior owners would not have sold had they known the information that X possessed. At the time of sale there was at least a possibility that X would exploit the information on which the transaction was based to garner additional profits. Thus, by a possible-harm standard, it appears probable that X would breach his fiduciary duties to A Corp. by purchasing C Corp. stock when, at the time of sale, the exploited information could subsequently cause harm to A Corp.

Additionally, Scenario 3 may present a breach of duty under the doctrine of corporate opportunity.^[55] However, the reach of corporate opportunity will likely be limited to situations in which companies have a practice of trading in stock substitutes.^[56] Nevertheless, in such a case, the expropriation of a corporate opportunity could potentially serve as the basis of 10b-5 liability under the possible-harm standard, where the company is so engaged.

While the possible-harm standard likely would not govern trades in substitute securities, in each of the scenarios analyzed here, some possible harm is at least conceivable. Thus, even under the possible-harm standard, trading in substitute securities is presumptively illegal.

B.             Tippees of Inside Information

Even in cases in which there is a transaction where the trader of securities is not an insider but received the inside information as a tippee, there still should be liability under the misappropriation theory. The formative case on tippee liability is Dirks v. SEC,^[57] which held that a tippee is liable under 10b-5 when the tipper breaches his duty by disclosing information for personal benefit and the tippee knows or should know of the tipper’s breach.^[58] Two scenarios will guide the analysis here:

Scenario 4: The same general facts as Scenario 1, but X sells to Outsider Y the information that A Corp. is going to manufacture Widget M. Y then short sells the stock of B Corp. and makes a tidy profit.

Scenario 5: Like Scenario 4, but X sells to Y his advice that Y should short sell the stock of B Corp. without giving any information about why he believes that is a profitable investment.

In Scenario 4, X breached a duty to his employer by directly disclosing confidential information for personal benefit.^[59] It can be inferred that Y, in purchasing information, also directly knew that X was breaching his fiduciary duty. The major remaining question is whether Y can avoid liability by trading in substitute securities. While Dirks was decided under the classical theory provided by Chiarella, the Second Circuit has held that the doctrine applies equally under the misappropriation theory.^[60] Therefore, Y inherits X’s fiduciary duty to disclose and breaches that duty under the misappropriation theory by trading in substitute securities.

Scenario 5 raises another issue: whether X breached any duty by disclosing, not the insider information directly, but the correlative information itself. Arguably, this is a disclosure of information that is not per se confidential. However, X could be considered to have breached a duty to A Corp. because X misappropriated confidential information for his own personal, private benefit. In addition, while the case was focused on personal benefit, not trades in substitute securities, Salman v. United States^[61] suggests that a tipper cannot do by tipping what he could not do directly.^[62] Therefore, so long as Y understands that X is still breaching a duty to A Corp. by disclosing the proposed substitute trade, Y would be liable.

C.             Liability of the Corporation Itself

While the corporation itself may be liable for trading on inside information,^[63] there appears to be no recognized theory on how the corporation, as an outsider, could be liable for trading in substitute securities.^[64] Most importantly, except by contract^[65] or control,^[66] the misappropriation theory would not apply to corporate trading. Given the limited scope for liability and the significant availability of short-term profits, it is surprising that companies do not engage in the practice more frequently.^[67]

IV.               Conclusion

Trading in substitute securities involves the holder of inside information trading in the securities of a firm that is not the source of the information. This Article concludes that such trading is illegal under Rule 10b-5. Under the misappropriation theory, a trader can violate Rule 10b-5 by breaching a duty to the source of the information. Employees or other insiders with a fiduciary relationship to the source breach their fiduciary duty when they use corporate information for personal gain. Therefore, an insider who uses corporate information to trade in substitute securities for personal gain breaches a duty to corporate source of that information and runs afoul of Rule 10b-5. Correspondingly, a tippee who receives that information from an insider with knowledge of the insider’s breach can inherit the breach and violate Rule 10b-5. However, as a corporation does not owe a duty to itself, it is not subject to enforcement under the misappropriation theory of Rule 10b-5—at least concerning its own information.

Like traditional insider trading, the debate over whether prohibiting trading in substitute securities is economically efficient is largely unresolved.^[68] However, considering that trading in substitute securities is presumptively illegal, as well as the general lack of enforcement actions in this area, the overall costs of trading in substitute securities may not justify diverting scarce resources from the enforcement of other areas of the law. Even if enforcement itself may not be socially efficient, certain policy reforms, such as increased disclosure requirements, may be socially optimal because they generally deter inefficient trading.^[69]

† J.D. Candidate, Harvard Law School, 2018. B.S. in Business Administration, Accounting and Finance, Georgetown University, 2014.

[1] Ian Ayres & Joe Bankman, Substitutes for Insider Trading, 54 Stan. L. Rev. 235 (2001).

[2] 17 C.F.R. § 240.10b-5 (2016) (“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) [t]o employ any device, scheme, or artifice to defraud, (b) [t]o 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) [t]o 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.”).

[3] Ayres and Bankman largely fail to state explicitly whether the insider trading is theoretically illegal, stating that “case law in this area is ambiguous,” Ayres & Bankman, supra note 1, at 256, and that “[m]ost counsel would caution employees in the possession of material nonpublic information not to trade in substitute stocks,” id. at 259. Other commentators have expressly concluded that substitute trading is not illegal. See Brian Bloch, Substitute Trading Eludes Market Abuse Rules, Global Risk Regulator (Sept. 4, 2015), https://www.globalriskregulator.com/Regions/Europe/Substitute-trading-eludes-market-abuse-rules (“Mark Astarita, a partner at US securities defence attorneys [firm] Sallah Astarita & Cox, emphasises that substitute trading is not inherently illegal.”).

[4] A notable example of substitute trading in practice is the conduct of Jay Gould in the nineteenth century: “When forming new telegraph companies to compete against the incumbent Western Union, [Jay Gould] consistently sold short Western Union stock. And this same maxim—sell thy rival’s stock short before entering—was used against Gould when a new steamship line began competing against his Pacific Mall company.” Ayres & Bankman, supra note 1, at 243.

[5] See id. at 241. Additionally, there might be two companies with correlated stock prices even though they are not in the same industry and do not share a specified relationship. See, e.g., Evan Gatev et al., Pairs Trading: Performance of a Relative-Value Arbitrage Rule, 19(3) Rev. Fin. Studies 797, 806–08 (2006) (finding that excess returns can be achieved through pairs trading with stocks that “do not necessarily belong to the same broad industry categories”).

[6] See Ayres & Bankman, supra note 1, at 247, 251.

[7] See id. at 242. Indeed, in that very case, there were options trading for four months prior to the announcement that bet on a fall in Polaroid stock—potentially indicating a trade in substitute securities. Id.

[8] For another example, see Ian Ayres and Stephen Choi, Internalizing Outsider Trading, 101 Mich. L. Rev. 313, 316 (2002) (“[A] biotech firm which knows it has just patented a particular gene may have a profitable opportunity to trade its rivals’ shares short.”).

[9] Cf. Ayres & Bankman, supra note 1, at 243–46.

[10] See id. at 248–49.

[11] See id.

[12] See id. at 250–51. For a more detailed analysis of the correlation and profit possible between two substitute firms, see Robert G. Hansen & John R. Lott, Profiting from Induced Changes in Competitors’ Market Values: The Case of Entry and Entry Deterrence, 43 J. Indus. Econ. 261 (1995); Hui Huang, Substitute Trading and the Effectiveness of Insider Trading Regulations (Oct. 2006) (unpublished manuscript), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=829425.

[13] Ayres & Bankman, supra note 1, at 251 (“The much higher rate of return per dollar invested may make substitute trading more attractive to employees than employers. It is not surprising, therefore, that we find that currently, informationally informed substitute trading is carried out by employees rather than employers.”).

[14] See Chiarella v. United States, 445 U.S. 222, 233 (1980) (“We cannot affirm petitioner’s conviction without recognizing a general duty between all participants in market transactions to forgo actions based on material, nonpublic information.”); id. at 235 (“We hold that a duty to disclose under § 10(b) does not arise from the mere possession of nonpublic market information.”).

[15] 40 S.E.C. 907, 912 (1961).

[16] See id. at 909. Ayres and Bankman conclude that the duty to disclose was traditionally extended only to corporate insiders, thereby implying that the duty to disclose extended only to the corporation itself and that trading substitute securities would therefore not be wrongful under the equal access theory. See Ayres & Bankman, supra note 1, at 252–54. However, the SEC in Cady, Roberts did not narrowly define to whom the duty was owed and implied that it was owed to any counterpart to the transaction. See Cady, Roberts, 40 S.E.C. at 911. Indeed, if the duty to disclose were solely derivative of the duty of loyalty to the corporation, it seems possible that the duty might only extend to the purchase of securities and not to the sale—the insider would not have a prior fiduciary relationship to a purchaser who was not an existing shareholder. In any case, how Cady, Roberts was subsequently interpreted is more in line with extending a duty to disclose based on mere possession of information. See, e.g., SEC v. Tex. Gulf Sulphur Co., 401 F.2d 833, 848 (2d Cir. 1968).

[17] Cady, Roberts, 40 S.E.C. at 912.

[18] Tex. Gulf, 401 F.2d at 848.

[19] Materiality is defined as “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” Basic Inc. v. Levinson, 485 U.S. 224, 231–32 (1988) (quoting TSC Indus. v. Northway, 426 U.S. 438, 449 (1976)).

[20] In each of the other theories below, the information will continue to be material.

[21] The equal access theory was overruled in Chiarella v. United States, 445 U.S. 222, 235 (1980).

[22] See infra Part III.A.3.

[23] 445 U.S. 222 (1980).

[24] Id. at 235.

[25] Id. at 230.

[26] See Dirks v. SEC, 463 U.S. 646, 655 n.14 (1983) (“Under certain circumstances, such as where corporate information is revealed legitimately to an underwriter, accountant, lawyer, or consultant working for the corporation, these outsiders may become fiduciaries of the shareholders. The basis for recognizing this fiduciary duty is not simply that such persons acquired nonpublic corporate information, but rather that they have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes.”); see also Ayres & Bankman, supra note 1, at 253–54.

[27] On the other hand, it is possible to imagine that X may have been internally compartmentalized from the plans of A Corp. and in fact may have received the information by reason of the company’s relationship with the supplier. If that were so, ignoring for the moment the difficulty of distinguishing the two events in practice, it would be possible for X to be treated as a corporate insider of the substitute firm.

[28] United States v. O’Hagan, 521 U.S. 642, 652 (1997).

[29] Id. at 647–48 (detailing the defendant’s purchase of call options in the target’s stock).

[30] Id. at 653.

[31] Ayres & Bankman, supra note 1, at 255–56.

[32] See id. at 259 (“Most companies, however, have no express limitations.”).

[33] See id. at 256.

[34] Id. at 256; cf. O’Hagan, 521 U.S. at 655 (noting that absent a “deception” of the source of the information, which is precluded by full disclosure, there can be no liability under the misappropriation theory).

[35] Ayres & Bankman, supra note 1, at 256.

[36] See infra Part III.A.3.i.

[37] See infra Part III.A.3.ii.

[38] Restatement (Third) of Agency, § 8.02 (Am. Law Inst. 2006). Additionally, the agent has a duty not to use property of the principal or communicate confidential information for the agent’s own purposes. Id. § 8.05. While not a direct disclosure of information, trading in substitute securities does communicate the effects of such confidential information by affecting the price of the substitute security. See Henry G. Manne, Insider Trading: Hayek, Virtual Markets, and the Dog that Did Not Bark, 31 J. Corp. L. 167, 179–80 (2005) (suggesting that trading in substitute securities, at some level, communicates to the management of the substitute firm the presence of nonmarket information that materially affects the value of the company). Even if trading in substitute securities does not directly breach the agent’s duty not to disclose confidential information, one can conceptualize insider information as property of the company that the agent cannot use for personal gain.

[39] Restatement (Third) of Agency, § 8.02 cmt. b (Am. Law Inst. 2006).

[40] Brophy v. Cities Serv. Co., 70 A.2d 5, 8 (Del. Ch. 1949); see also, e.g., Diamond v. Oreamuno, 248 N.E.2d 910, 912 (N.Y. 1969) (“[A] corporate fiduciary, who is entrusted with potentially valuable information, may not appropriate that asset for his own use even though, in so doing, he causes no injury to the corporation.”). The Supreme Court cited Diamond favorably in a violation of mail and wire fraud statutes where the defendant had “fraudulently misappropriated ‘property[.]’” Carpenter v. United States, 484 U.S. 19, 24, 27–28 (1987). On the other hand, at least under Delaware law, a self-dealing transaction with a controlling shareholder will only trigger the strenuous analysis of entire fairness if the fiduciary receives something to the “exclusion of, and detriment to,” those with which he stands in a fiduciary relationship. Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971). While not directly applicable, the doctrine does lend some credibility to the possible-harm limitation on the misappropriation theory, at least with respect to insiders who are not legal agents of corporations. Notably, however, the net effect of both a state law incorporation and a possible-harm standard would be such that directors might have a lower risk of Rule 10b-5 liability than employees or other insiders. This split seems particularly unlikely from a policy perspective given that directors may have equal ability and opportunity to misappropriate corporate information.

[41] Ayres & Bankman, supra note 1, at 256.

[42] Restatement (Third) of Agency, § 1.02 (Am. Law Inst. 2006) (“Whether a relationship is characterized as agency in an agreement between parties or in the context of industry or popular usage is not controlling.”); see also id. § 8.06 cmt. b (“Common-law agency does not accord effect to all manifestations of assent by a principal that purport to eliminate or otherwise affect the fiduciary duties owed by an agent. This is so for two distinct reasons: (1) the law, and not the parties, determines whether a particular relationship is one of agency as defined in § 1.01; and (2) the law imposes restrictions on the efficacy of a principal’s manifestations of assent in the interest of safeguarding the principal’s intention in creating a relationship of common-law agency.”).

[43] Id. § 8.06.

[44] See, e.g., Salman v. United States, 137 S. Ct. 420, 422 (2016); United States v. O’Hagan, 521 U.S. 642, 643 (1997); Dirks v. SEC, 463 U.S. 646, 646–47 (1983). O’Hagan mentions state law only as a backdrop in the event an insider discloses to the source of the information. 521 U.S. at 655.

[45] See Stephen Bainbridge, Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Wash. & Lee L. Rev. 1189, 1190–91 (1995) (“What is the precise fiduciary duty at issue? Is the source of that duty federal or state law? Despite over a decade of experience with the fiduciary duty requirement, neither of these questions has a clear and convincing answer.”). But see Nolfi v. Ohio Kentucky Oil Corp., 675 F.3d 538, 549 (6th Cir. 2012) (incorporating state law for a Rule 10b-5 claim).

[46] See, e.g., O’Hagan, 521 U.S. at 642; United States v. Cusimano, 123 F.3d 83, 85 (2d Cir. 1997). Ayres and Bankman cite several enforcement actions against insiders trading in stocks of suppliers, although each case involved an express contractual prohibition on trading on inside information. See Ayres & Bankman, supra note 1, at 257; see also, e.g., United States v. Bryan, 58 F.3d 933, 938 (4th Cir. 1995).

[47] Ayres & Bankman, supra note 1, at 257.

[48] O’Hagan, 521 U.S. at 656.

[49] On the other hand, a rule where the insider breaches a duty to the source of information merely by trading on that information comes close to the equal access theory expressly overruled in Chiarella v. United States. 445 U.S. 222 (1980); see also O’Hagan, 521 U.S. at 690–91 (Scalia, J., dissenting) (“Even if it is true that trading on nonpublic information hurts the public, it is true whether or not there is any deception of the source of the information. Moreover, as we have repeatedly held, use of nonpublic information to trade is not itself a violation of § 10(b). E.g., [Chiarella, 445 U.S. at 232–33]. Rather, it is the use of fraud ‘in connection with’ a securities transaction that is forbidden. Where the relevant element of fraud has no impact on the integrity of the subsequent transactions as distinct from the nonfraudulent element of using nonpublic information, one can reasonably question whether the fraud was used in connection with a securities transaction.”).

[50] See Dirks v. SEC, 463 U.S. 646, 663 (1983) (“[T]he initial inquiry is whether there has been a breach of duty by the insider. This requires courts to focus on objective criteria, i.e., whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.”).

[51] In fact, the insider may not even have to “use” the information; under current Second Circuit precedent, the government need only show that the “defendant[] purchased or sold securities while knowingly in possession of the material nonpublic information.” United States v. Rajaratnam, 719 F.3d 139, 159 (2d Cir. 2013) (quoting United States v. Teicher, 987 F.2d 112, 119 (2d Cir. 1993)). This would imply that deriving personal benefit in a securities transaction while knowingly possessing material information would constitute a breach of fiduciary duty; there would be no requirement to prove that the inside information was used or relied upon by the insider.

[52] Ayres & Bankman, supra note 1, at 257.

[53] Given this analysis, a possible-harm standard without a cognizable limitation would all but merge with the fiduciary-sourced default rule. A reasonable limitation would be a “plausible possible-harm standard,” where the remoteness of the harm would be taken into consideration.

[54] 134 S. Ct. 1058, 1066 (2014) (interpreting 15 U.S.C. § 78bb(f)(1)(A) (2014)); see also id. at 1069–71 (applying the interpretation to Rule 10b-5).

[55] See, e.g., Broz v. Cellular Info. Sys., 673 A.2d 148 (Del. 1996).

[56] See Ayres & Bankman, supra note 1, at 257.

[57] 463 U.S. 646 (1983).

[58] Id. at 660; see also Salman v. United States, 137 S. Ct. 420, 423 (2016) (“The tippee acquires the tipper’s duty to disclose or abstain from trading if the tippee knows the information was disclosed in breach of the tipper’s duty, and the tippee may commit securities fraud by trading in disregard of that knowledge. In [Dirks, 463 U.S.], this Court explained that a tippee’s liability for trading on inside information hinges on whether the tipper breached a fiduciary duty by disclosing the information. A tipper breaches such a fiduciary duty, we held, when the tipper discloses the inside information for a personal benefit. And, we went on to say, a jury can infer a personal benefit—and thus a breach of the tipper’s duty—where the tipper receives something of value in exchange for the tip or ‘makes a gift of confidential information to a trading relative or friend.’” (quoting Dirks, 463 U.S. at 664)).

[59] Personal benefit, in this simplified scenario, is directly obtained through pecuniary gain. Dirks explicitly provided a wider definition of any “direct or indirect personal benefit.” 463 U.S. at 663; see also Salman, 137 S. Ct. at 427–28.

[60] SEC v. Obus, 693 F.3d 276, 285–86 (2d Cir. 2012) (“The Supreme Court’s tipping liability doctrine was developed in a classical case, Dirks, but the same analysis governs in a misappropriation case.” (citing United States v. Falcone, 257 F.3d 226, 233 (2d Cir. 2001))).

[61] 137 S. Ct.

[62] Cf. id. at 427–28 (“[The tipper] would have breached his duty had he personally traded on the information here himself then given the proceeds as a gift to [the tippee]. . . . It is obvious that [the tipper] would personally benefit in that situation. But [the tipper] effectively achieved the same result by disclosing the information to [tippee], and allowing him to trade on it. Dirks appropriately prohibits that approach, as well. . . . Dirks specifies that when a tipper gives inside information to ‘a trading relative or friend,’ the jury can infer that the tipper meant to provide the equivalent of a cash gift. In such situations, the tipper benefits personally because giving a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds.” (citations omitted)).

[63] See Mark J. Loewenstein & William K.S. Wang, The Corporation as Insider Trader, 30 Del. J. Corp. L. 45, 70–72 (2005). The corporation may also be criminally liable under Rule 10b-5 for the conduct of its employees. See, e.g., United States v. S.A.C. Capital Advisors, L.P., No. 13 Civ. 5182 (RJS), 2013 U.S. Dist. LEXIS 160216 (S.D.N.Y. Nov. 5, 2013). For a more detailed discussion of the use of direct corporate trading as a substitute for individual officer inside trading, see Jesse M. Fried, Insider Trading Via the Corporation, 162 U. Pa. L. Rev. 801 (2014).

[64] Ayres & Bankman, supra note 1, at 259. Ayres and Bankman note that a former chief economist of the SEC stated the following regarding corporate liability for trading in substitute securities: “All [eight securities lawyers] said that 1) it is legal to trade rivals’ stock; 2) even at its most imperious, the SEC has never suggested that this is illegal; and 3) they had never heard of such a case being brought, or even episodes of such trading questioned.” Id. (quoting Robert G. Hansen & John R. Lott, Jr., Profiting from Induced Changes in Competitors’ Market Values: The Case of Entry and Entry Deterrence, 43 J. Indus. Econ. 261, 273 n.16 (1995)).

[65] Ayres and Bankman note that a company (L) can be deemed a temporary insider of another company (M) through contract, such that trading by L on the stock of M based on information obtained through the contract would constitute a claim under classical fiduciary duty theory. See Ayres & Bankman, supra note 1, at 259 n.68. Likewise, using that information to trade in a third company’s stock could violate L’s contractually-created duty to M under the misappropriation theory, such that L would be liable under Rule 10b-5 for a trade in substitute securities.

[66] Misappropriation would apply as follows: As the controlling person of another company (SubCo), ParCo would be subject to fiduciary duties in its management of another company. See, e.g., Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334, 1344 (Del. 1987) (“Under Delaware law a shareholder owes a fiduciary duty only if it owns a majority interest in or exercises control over the business affairs of the corporation.” (citations omitted)). If the directors of ParCo used confidential information derived from their control of SubCo for the benefit of ParCo and ParCo’s shareholders (in connection with a transaction in securities), ParCo could be liable under 10b-5 for misappropriating information in violation of a duty to ParCo. Thus, in the case of Weinberger v. UOP, 457 A.2d 701 (Del. 1981), where directors used subsidiary information to prepare a feasibility study for the parent in connection with a merger agreement, the controlling-shareholder company could be subject to 10b-5 liability under the misappropriation theory.

[67] See Ian Ayres & Barry Nalebuff, Don’t Sell Us Short, Forbes (Feb. 2, 2004 12:00 AM), http://www.forbes.com/forbes/2004/0202/057.html (exploring why corporations do not engage in substitute trading, and suggesting that it is because it seems “distasteful” or “unsportsmanlike”).

[68] In general, the arguments for and against a prohibition on trading in substitute securities largely tracks the arguments for and against insider trading more generally: whether the efficiency benefits from insider trading (principally, more accurate pricing) outweigh the efficiency costs (namely, management incentives and inefficient compensation). Ayres & Bankman, supra note 1, at 267–69. For an example of when trading in substitute securities would provide pricing information, see Henry G. Manne, Insider Trading: Hayek, Virtual Markets, and the Dog that Did Not Bark, 31 J. Corp. L. 167, 179–180 (2005). A primary distinction, however, is that in the context of substitute securities trading, most of the costs and benefits are borne by the shareholders of the correlated company and not by the company that is the source of the information. See Ayres & Bankman, supra note 1, at 275 (noting that the losses to shareholders are of another firm, as are the benefits from accurate pricing). Due, in larger part, to inefficiencies in accurately compensating employees who have the right to trade in substitute securities, Ayres and Bankman conclude that trading in substitute securities is more likely than not to be economically inefficient and therefore should be prohibited. See id. at 279. However, Ayres and Bankman may have failed to fully consider the effects that prohibiting trading in substitute securities might have on the incentives of market participants. See Bruce H. Kobayashi & Larry E. Ribstein, Outsider Trading as an Incentive Device, 40 U.C. Davis L. Rev. 21, 24–25 (2006) (finding that prohibiting trading in substitute securities decreases incentives for individuals to undertake activities that are both socially productive and that produce tradable information).

[69] Ayres & Bankman propose numerous disclosure requirements for the company including identification of core substitutes (suppliers, customers, rivals, and quantitative correlates), whether the firm granted or denied permission to employees to trade, disclosure of substitute trades under Rule 16b, and disclosure of the implicit value of stock trading as executive compensation. See Ayres & Bankman, supra note 1, at 285–90.