Three years later, in Dirks v. SEC, Powell more directly addressed his concerns about the relation between inside information restrictions and market efficiency. In 1973 the SEC, under the leadership of Chairman John S. R Shad, had censured Dirks, a securities analyst, for tipping The Wall Street Journal and some of his customers about a growing fraud scandal that he had uncovered at Equity Funding.(38) In earlier testimony to Congress, while cautioning against how exaggerated perceptions of widespread insider trading undermined investor confidence, Chairman Shad nonetheless warned that the SEC would "come down with hobnail boots to give some shocking examples to inhibit the activity."(39)
The censure ironically cited Dirks for violating the insider trading prohibition by repeating the allegations of fraud before public disclosure, despite the fact that Dirks had played a major role in uncovering the fraud at Equity Funding. In reversing the SEC censure, the Supreme Court rejected the SEC's interpretation of Rule 10b-5 coverage for tippee liability. Powell, again relying on the common law of fraud, strenuously argued that Chiarella required a breach of a specific fiduciary duty, and that Dirks's sources clearly violated no duty. At oral argument, Powell questioned SEC Solicitor Paul Gonson just how far the chain of liability went.
"If Dirks told a Wall Street Journal reporter," asked Powell, "who then told a friend, who then sold Equity Funding stock, is Dirks liable?" Gonson replied that under the SEC theory of liability, the chain went "as far as persons who receive information from an inside source" because "people who buy stock assume the risk that the company may not do well, but not that insiders will dump their stock and bail out."(40)
In a decision authored by Justice Powell, the Supreme Court limited tippee insider trading liability to situations that involved breaches of duty that closely resembled traditional fraud actions in state corporate law. The Court rejected the SEC's view that anyone who received non-public information from a corporate insider "inherited" the insider's legal obligation to either make the information public or abstain from trading. A finding of insider trading liability would thereafter turn, to a great extent, on the motive of the insider, on whether the "insider personally benefited, directly or indirectly, from his disclosure." It was the kind of definition of insider trading requiring a showing of motivation that the SEC had long hoped to avoid.(41)
(38) Dirks v SEC, 463 U.S. 646 (1983).
(39) Kenneth B. Noble, "S.E.C. Chief Plans Insider Trade Curb," The New York Times, October 26, 1981, D1.
(40) Linda Greenhouse, "Dirks Gets His Day in Court," The New York Times, March 22, 1983, D1.
Paul Gonson began working at the SEC in 1961 and held a number of positions during his 37-year career at the agency. He started out in the Division of Corporate Regulation, then transferred in 1967 to the Office of General Counsel where he became primarily an appellate attorney. When David Ferber retired from his post as the Solicitor in 1979, Gonson was appointed to take his place. During the next 20 years, he worked on a number of enforcement cases, primarily insider trading, many of which he argued before the Supreme Court. In 1998, he retired from the SEC and joined the firm of Kirpatrick & Lockhart.
