Correcting "The Ethicist" on Insider Trading

Thom Lambert —  23 January 2006

In yesterday’s New York Times Magazine, an anonymous reader posed the following question to The Ethicist:

I am a subspecialty physician without primary responsibility for patients. I consulted on the care of the C.E.O. of a major company, the seriousness of whose illness was not being fully disclosed to shareholders. I own stock in this company. Once I complete my consultation, may I ethically sell my shares, motivated by the information I gained as a doctor?

The Ethicist responded that “[m]edical ethics do not forbid this trade, but investor ethics — a curious phrase, given recent headlines — do, so you may not make this sale.” The Ethicist went on to explain that the trade would likely be deemed illegal insider trading under the misappropriation theory.

This response — medical ethics present no bar to this trade, but the misappropriation theory does — cannot be right. Here’s why:

Insider trading is illegal, the courts reason, because it amounts to fraud in connection with the sale or purchase of a security. Fraud, of course, is lying. But where’s the lie when one merely purchases or sells a stock on an anonymous exchange? There’s no affirmative misstatement (the trader never says anything at all, other than “I’d like to purchase (or sell) x shares of y stock”). The lie must therefore be a failure to speak. Such an omission, though, cannot be considered a lie unless the “non-speaker” has some duty to speak.

Courts have recognized two theories under which such a duty may arise. Under the “classical theory,” the duty to speak arises because the trader is a fiduciary of her trading partner. Thus, an insider of a company must speak (specifically, must disclose her material non-public information) before buying company stock from an incumbent shareholder, to whom she owes fiduciary duties. Her failure to speak in the face of this duty would constitute the “lie” necessary for securities fraud. Under the “misappropriation theory,” the duty arises because of the relationship between the trader and the source of her non-public information. If the trader has essentially promised the source of her information that she won’t use the source’s information to her advantage, then trading on the information without first telling the source of her intention to do so would amount to fraud. As the Supreme Court put it, “the deception essential to the misappropriation theory involves feigning fidelity to the source of information.” United States v. O’Hagan, 521 U.S. 642, 655 (1997).

So how does this complicated (and sort of silly) body of law apply to the doctor’s dilemma? There’s clearly no duty to speak under the classical theory, for the doctor is not an insider of the corporation at issue and thus owes no fiduciary duty to his trading partner. The Ethicist says liability would arise under the misappropriation theory. But misappropriation liability requires “feigning fidelity to the source of information” — i.e., saying you won’t personally profit from the source’s information but then turning around and doing so without disclosing your plans. There could be no liability, then, unless the doctor had essentially told his patient that he wouldn’t use the patient’s information.

Now, if the doctor were a fiduciary of the patient, such an assurance (“I won’t use your information for my profit”) would be implied by the law, for the law imposes duties of undivided loyalty on fiduciaries. But the doctor/patient relationship, while certainly a relationship of trust and confidence, is not technically a fiduciary relationship. Thus, the duty not to use a patient’s information for personal profit must come from elsewhere. It could, of course, arise from contract (i.e., the contract might say or imply that the doctor won’t use the patient’s information). We can assume, though, that no such contractual provision existed here; otherwise, the doctor’s question to The Ethicist would’ve been a pretty easy one (it’s generally unethical to break your promises). Finally, the duty could arise from the background rules of ethics governing the doctor/patient relationship. The Ethicist, though, says the rules of medical ethics would not forbid the doctor’s trade.

If The Ethicist is right on this point, then the doctor (1) has no fiduciary duty not to use the information, (2) presumably didn’t contractually promise not to use the information (if he did, why the question?), and (3) has no ethical duty not to use the information. His secret use of the information, then, could hardly “feign[] fidelity to the source of information” and thus could not be fraudulent.

Now, would I advise the doctor to make this trade? No way. The SEC has a long history of seeking expansion of the insider trading laws and might, if aware of all the facts, come after the doctor with some concocted theory of liability. Under current doctrine, though, the trade would not seem fraudulent.

Thom Lambert


I am a law professor at the University of Missouri Law School. I teach antitrust law, business organizations, and contracts. My scholarship focuses on regulatory theory, with a particular emphasis on antitrust.

9 responses to Correcting "The Ethicist" on Insider Trading


    Mark: Thanks for your comments. A few thoughts–

    Like you, I’m sure the SEC would take the position that the trade contemplated by The Ethicist constitutes securities fraud under the misappropriation theory. I don’t really care what the SEC thinks. The SEC has, from the get-go, attempted to expand the scope of the insider trading prohibition. The Supreme Court, though, has consistently said (most notably, in O’Hagan) that there can be no Section 10(b)/Rule 10b-5 liability absent a deception.

    I therefore disagree with your initial assertion that the fraud in a misappropriation “is not the lie, it is the breach of a confidential relationship.” The O’Hagan court made crystal clear that the deception in a misappropriation case is using confidential information to your benefit while you’re saying that you’re NOT doing so. That’s a lie, and it thus violates Rule 10b-5.

    If you’ve never said that you’re not using confidential information for your benefit, then your doing so can’t be a lie. Doctors represent to their patients that they’re not disclosing confidential information (so disclosure might constitute fraud). But, at least according to The Ethicist, they don’t make a similar representation that they’re not using such information for their benefit. If that’s right (and there’s no contractual assurance to that effect), the trading at issue here would not involve a lie. O’Hagan says that if there’s no such lie, there’s no insider trading liability.

    I’m not familiar with the details of Materia, but, assuming it’s inconsistent with the analysis I’ve presented here, I’d consider it (like Willis) to have been preempted by O’Hagan.


    The fraud in the misappropriation theory is not the lie, it is the breach of a confidential relationship. At least that is the case according to the SEC.

    The original misappropriation theory case (on the civil side) was Materia – a proofreader in a financial printing firm. He was accused of figuring out the targets of tender offers and trading on that information. Information that he “stole” from his employer, with whom he had a fiduciary duty, and the employer had a fiduciary duty to the offeror.

    I do not think there is any doubt that the SEC would take the position that a doctor has a duty to keep his patient’s confidences, and not to use those confidences for his personal gain. Therefore, like Materia, and he breached that duty when he obtained the information and purchased (or sold) the security.

    I am not familiar with Willis, and while it may predate O’Hagan, it does not predate Materia, nor the other decisions in the circuits that adopted the misappropriation theory, which ultimately led to O’Hagan.

    Materia never promised anything to his employer, just as our doctor never promised anything to his patient. The obligation that they both have in common however, is to protect the confidences of their employer (patient).

    I certainly agree with Professor Lambert regarding the SEC’s authority to enact rules which change the meaning of the statute, but given the long line of misappropriation cases, does the SEC even need that statute?

    The courts effectively wrote the “fraud in connection with” requirement of 10b out of the statute. As it stands today, the statute is applied as if it says a “fraud that results in the purchase or sale of a security.”

    Is it such a stretch to call the violation of the doctor-patient privilege a fraud?


    In response to my esteemed colleague, Royce Barondes:

    I’m not persuaded by the Willis decision, as it pre-dates O’Hagan and seems to assume that the gravamen of a misappropriation offense is some kind of breach of the duty of confidence. It is not. It is saying one thing (“I won’t use your information to profit”) and secretly doing another. Apparently (if what The Ethicist says is right), the doctor here never said he wouldn’t use his patient’s information for personal profit, though he undoubtedly promised not to disclose the information.

    With regard to the relevance of Rule 10b5-2, see my previous comment. The SEC cannot, via rule promulgated pursuant to its authority under Section 10(b), create duties not to use confidential information for profit. Those duties are a matter of state law, ethical codes, and/or contract.


    Both an SDNY opinion and the SEC release initially proposing Rule 10b5-2 (Release No. 33-7787, 1999 SEC LEXIS 2696 (December 20, 1999)) indicate that a psychiatrist cannot trade on patient information. I would think it would be difficult to treat a physician differently.

    A pertinent extract from the SEC release follows:

    n109 Proposed para. (b) does not enumerate relationships that existing case law already recognizes as providing a clear basis for misappropriation liability: for example, lawyer-client, O’Hagan; employee-employer, Carpenter, psychiatrist-patient, United States v. Willis, 737 F. Supp. 269 (S.D.N.Y. 1990), appeal dismissed, 778 F. Supp. 205 (S.D.N.Y. 1991). As the O’Hagan case demonstrates, an individual working at a professional firm may be liable for misappropriating information about a particular matter even if he or she is not personally working on that matter.


    One more thought on Bill’s insightful comments: Undoubtedly, Rule 10b5-2 (in which the SEC attempted to articulate “a non-exclusive list of three situations in which a person has a duty of trust or confidence for purposes of the ‘misappropriation’ theory”) would say that the relationship here is one of trust and confidence. Indeed, the rule includes situations in which “the person communicating the material nonpublic information and the person to whom it is communicated have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the material nonpublic information expects that the recipient will maintain its confidentiality.” Communications in connection with the doctor/patient relationship would almost certainly be included here.

    The SEC cannot, however, expand the scope of Section 10(b) via rule. Section 10(b) outlaws only deception. The deception at issue in a misappropriation case is “two-facedness”: The trader tells the source that he won’t use the source’s information, but he then turns around and secretly does so.

    Thus, to give rise to misappropriation liability for use of the source’s information, the relationship at issue must not simply be one of trust and confidence (where telling the information to another would be a breach of trust), it must also be one in which the recipient of the information has somehow represented or implied that he will not USE the information for personal profit.

    The SEC is likely trying to use Rule 10b5-2 to read into non-fiduciary trust relationships some implicit representation that the information exchanged will not be used for personal profit. But the commission’s enabling legislation — Section 10(b) — likely does not give it the authority to determine the substance of the underlying duties whose clandestine violation constitutes fraud. Those duties are determined by (state) fiduciary duty law, private contract, and perhaps rules of ethics.


    Bill: All good points. I’m not 100% sure my analysis is correct, but here’s a stab.

    For use of confidential information to constitute deception, which is required by Section 10(b), there has to be a relationship of trust or confidence where one aspect of that trust/confidence is an assurance that information conveyed will not be used to personal advantage. The Ethicist says that medical ethics do not imply this sort of assurance on the part of a doctor (“Medical ethics do not forbid this trade.”). If that’s right — and I have no idea if it is or isn’t; I’m taking The Ethicist at his word — then there’s no assurance by the doctor that he won’t use the information to personal advantage, and his doing so without disclosing his plans thus cannot constitute deception.

    So perhaps I am saying that, in the context of a non-familial, non-fiduciary doctor/patient relationship, the duty not to benefit from the patient’s information must come either from contract, or perhaps from the medical center’s internal rules (which also presumably wouldn’t forbid the trade here; otherwise the doctor’s question of The Ethicist would be too easy), or from background ethical rules. We can eliminate the first two sources of duty, and The Ethicist has eliminated the third. There thus is no duty not to use the information, so secretly doing so can’t be fraud.

    Of course, as I said before, I’d never advise a client to make this trade. The SEC would be all over it. As a strict legal matter, though, The Ethicist’s legal analysis — no ethical barrier, but potential misappropriation liability — seems wrong.

    This might make a good exam question, no?


    Given Rule 10b5-2, shouldn’t “relationship of trust or confidence” be on your list? Or are you saying that (1) through (3) constitutes the universe of relationships of trust or confidence? If so, what about Rule 10b5-2(b)(3) which establishes a presumptive duty of trust and confidence based on familial relationship alone?


    Bill: The relationship at issue in O’Hagan was obviously a fiduciary relationship (the trader was a member of the law firm representing the source of the information), but the theory approved in the decision has been stretched to cover non-fiduciary relationships of trust (particularly, as you say, in Rule 10b5-2). It seems to me, however, that the relationship at issue MUST involve some sort of assurance on the part of the trader that he will not use his source’s information to his personal advantage. Otherwise, secret use of the information could not constitute the “feigned fidelity” that turns misappropriation into fraud. In a non-fiduciary relationship, the required assurance could arise from contract or from background ethical rules. In the factual scenario presented to The Ethicist, there presumably was no express or implied contractual assurance that the doctor would not use the information at issue for personal advantage, and The Ethicist says (and I’m not sure if he’s right) that the rules of medical ethics would not imply such an assurance. Absent (1) a fiduciary relationship, (2) a contractual promise not to use the information at issue, and (3) an ethical duty not to use the information, I don’t see how use of the information at issue could “feign fidelity” to the patient. If there’s no feigned fidelity, there’s no fraud, and thus no liability under Rule 10b5. Am I missing something?


    Thom: Is it established that O’Hagan requires a breach of fiduciary duty as opposed to a breach of a relationship of trust or confidence? The O’Hagan opinion throws both phrases around and perhaps uses them interchangeably. Also, Rule 10b5-2 refers to duties of trust or confidence and not fiduciary duties. This is a point I’ve meant to research but never have gotten around to it. Have you looked at it?