Pari delicto doctrine and insider trading

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In my Oct. 31 column, I wrote about a Supreme Court case that used the pari delicto doctrine to prevent a broker from recovering the unpaid purchase price of stock market trades, which it made for a client in violation of the mandatory closeout rule under the Revised Securities Act (Abacus Securities Corp. vs. Ampil [483 SCRA 315, 27 February 2006]).

Can the case be applied to other market transactions, such as insider trading? For example, if an investor trades on the basis of nonpublic material information given to him by a listed company or his broker, and he sustains damages because the so-called inside information turns out to be false, can he sue them for damages? Can the company and broker raise the pari delicto defense to bar the client from recovering damages from them?

There is a precedent from the Supreme Court of the United States for this situation. In Bateman Eichler v. Berner (472 US 299 (1985]), Lazzaro, an employee of a stock brokerage firm (Bateman), falsely represented that he had some inside information on the growth prospects of a company. He induced several clients of Bateman to purchase stock in the company. The investors alleged that they inquired from the president of the company (Neadeau) whether Lazzaro’s tips were accurate. Neadeau stated that the information was “not public knowledge” and “would neither confirm nor deny those claims,” but allegedly advised clients that “Lazzaro was very trustworthy and a good man.”

Claiming that they incurred substantial trading losses as a result of the conspiracy between Lazzaro and Neadeau, the investors later sued for damages based on Rule 10b-5, which was the governing law for insider trading in the United States. Bateman contended that, since the clients had themselves attempted to trade based on insider, albeit incorrect, information, they were barred from recovering damages under the pari delicto defense.

The issue was whether the pari delicto defense precluded investors from suing the tipping insider for stock fraud.

Speaking through Justice Brennan, the US Supreme Court ruled that the pari delicto defense did not preclude the investors from suing the tipping insider and stockbroker for fraud. Traditionally, the defense precluded recovery by a wrongdoing plaintiff on the notion that courts should not lend aid to wrongdoers. However, the doctrine will not bar a suit where (1) the defendant’s wrongdoing equals or outweighs the plaintiff’s, and (2) allowing the suit will serve important public purposes.

The Supreme Court held that insiders and broker-dealers who selectively disclose material nonpublic information commit a potentially broader range of violations than the investors, or tippees, who trade on the basis of that information. A tippee trading on inside information will, almost always, be guilty of fraud against individual shareholders, a violation for which the tipper shares responsibility. But the insider, in disclosing such information, also breaches fiduciary duties toward the issuer itself.

The Court held that, denying the in pari delicto defense would best promote protection of the investing public and the national economy. First, it promotes the important goal of exposing wrongdoers. Second, deterrence of insider trading most frequently will be maximized by bringing enforcement pressures to bear on the sources of such information—corporate insiders and broker-dealers. Third, insiders and broker-dealers often will be more responsive to the deterrent pressures of potential sanctions. Finally, there are means other than the in pari delicto defense to deter tippee trading. Although there might well be situations in which the relative culpabilities of tippees and their sources merit a different mix of deterrent incentives, in cases such as the instant one, the public interest will most frequently be advanced if defrauded tippees are permitted to expose illegal practices by corporate insiders and broker-dealers.

Whether or not our courts of law will apply the Bateman decision in the Philippine context remains to be seen. As we lawyers know, foreign court decisions only have a persuasive, not binding, effect on Philippine courts.

(The author, formerly president and chief executive officer of the Philippine Stock Exchange, is now co-managing partner and head of corporate and special projects department of the Angara Abello Concepcion & Regala Law Offices (Accralaw). The views in this column are solely the author’s and should not in any way be attributed to Accralaw. The author may be contacted through francis.ed.lim@gmail.com.)