Markets in Financial Instruments Directive – MiFID

Most legal systems contain rules prohibiting insider trading and market manipulation to bolster investor confidence in the marketplace for financial instruments. These prohibitions, while arguably of insignificant economic value, are deemed essential to provide a level playing field for investors. Take the United States and European Union legislation as exemplars of different approaches.

Section 10(b) of the Securities Exchange Act of 1934 prohibits the use of any ‘manipulative or deceptive device’ in the purchase or sale of any security and authorizes the SEC to promulgate rules to protect investors. (Note, Stock Option “Springloading”: An Examination of Loaded Justifications and New SEC Rules, 33 J. Corp. L. 777, 786 (2008))
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Rule 10(b)(5) prohibits,

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 a security. (17 C.F.R. § 240.10b-5 (2006); see also 17 C.F.R. § 240.10b5-1 (2006) (defining “manipulative and deceptive devices” and “on the basis of” material nonpublic information for purposes of Rule 10b-5 insider trading actions, and identifying affirmative defences)
– see reference list)

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Insider trading jurisprudence, due to the parsimonious language of Rule 10(b)(5) that does not explicitly prohibit inside trading, primarily has developed ad hoc through opinions of the United States Supreme Court, SEC rule making, and lower court opinions. While this ad hoc approach introduces dissonance into the coherence of theory, enforcement intensity of SEC has established the United States as the premier legal regime for punishing wrongdoers.

While insider trading law remained dormant for approximately 40 years, the United States Supreme Court set the base theory in the seminal case of In Re Cady, Roberts & Co., as further developed in Dirks v. S.E.C., and Chiarella v. U.S (In re Cady, Roberts & Co., 40 S.E.C. 907 (1961); Chiarella v. U.S., 445 U.S. 222 (1980), and Dirks v. U.S., 463 U.S. 646 (1983). An observer has noted that the origin of the prohibition against insider trading derives from the corporate law principles of fiduciary duties of corporate directors and officers, and that it was not until the federal Securities Acts of 1933 and 1934 that the matter became principally a subject of federal law. Stephen M. Bainbridge, An Overview of US Insider Trading Law: Lessons for the EU?, Research Paper No. 05-5, UCLA School of Law (2004) available at http://ssrn.com/abstract=654703).

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In SEC v. Texas Sulphur Co, the Court of Appeals (401 F.2d 833 (2nd Cir. 1968)(noting in footnote 9 to the opinion the intent to persuade the public that insiders cannot unfairly profit from the privileges of their office) for the Second Circuit commented that a rationale for prohibiting insider trading was to “eliminate the idea that the use of inside information for personal advantage was a normal emolument of corporate office”. “Insider trading rules” purportedly instil investor confidence by creating the perception that the evaluation of investment risks, and therefore profit making, is equal for all market participants. The decisions adopted a “disclose or refrain” from trading rule. Subsequently, in response to adverse decisions the federal government suffered in Chiarella and Dirks, the SEC promulgated Rule 14e-3 to prohibit any person from trading in target company securities based on non-public information. In addition, the United States Supreme Court in US v. O’Hagan adopted the so-called “misappropriation” theory providing that persons in possession of inside information that lack traditional fiduciary obligations commit fraud if they trade on that information in breach of a duty owed to the source of that information (521 U.S. 642 (1997)).

By contrast to the United States, the Member States of the European Union prohibited insider trading by statute (E.g., Criminal Justice Act 1993, ch. 36, part V, §§ 56, 60(4), in Alcock, “United kingdom” in International Securities Regulation vol. 5, bklt. 1, 30 (R. Rosen ed. 1994). Citation is borrowed from Marc I. Steinberg, Insider Trading – A Comparative Perspective, p. 17 available at http://www.imf.org/external/np/leg/sem/2002/cdmfl/eng/steinb.pdf). The European Union entered the field of regulating “insider dealing” in 1989 by Council Directive 89/592/EEC coordinating regulations on insider dealing. Given the rudimentary nature of this Directive and the accelerated pace for the development of a single market in services, the Community adopted Directive 2003/6/EC of 28 January 2003 on insider dealing and market manipulation (market abuse). Article 1.1 defines “inside information”:

Inside information shall mean information of a precise nature which has not been made public, relating, directly or indirectly, to one or more issuers of financial instruments or to one or more issuers of financial instruments and which, if it were made public, would be likely to have a significant effect on the prices of those financial instruments or on the price of related derivative financial instruments (Directives subsequently issued further refine the implementation of Directive 2003/6/EC)

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The Recitals explain the rational and objectives of the Directive. Consistent with generally accepted theory, Recital 2 states,

An integrated and efficient financial market requires market integrity. The smooth functioning of securities markets and public confidence in markets are prerequisites for economic growth and wealth. Market abuse harms the integrity of financial markets and public confidence in securities and derivatives.

Recital 15 further provides,

Insider dealing and market manipulation prevent full and proper market transparency, which is a prerequisite for trading for all economic actors in integrated financial markets.

In addition, the Directive seeks to establish a “level playing field in Community financial markets”.

The two exemplars show that each jurisdiction unequivocally assume that the law must prohibit insider trading to promote investor confidence in the financial markets and to deepen the liquidity of the markets through greater retail activity. Without questioning the validity of the assumption, rules that prohibit insider trading are a necessary, but not sufficient, pillar upon which to build a securities market.