The campaign against the supposed evils of insider trading hit a big bump in the road in United States v. Newman, when the Court of Appeals for the Second Circuit overturned the conviction of two hedge fund managers who had traded on tips about Dell and NVIDIA.[1]
The Supreme Court has held that to be found guilty of insider trading, a tippee must (or should) know that the source tipper violated a fiduciary duty (or similar obligation) in disclosing material nonpublic information.[2] This usually requires some evidence that the tipper was effectively bribed (although it may suffice to show that the tipper wanted to make a gift of valuable inside information). But in Newman, the prosecutors prevailed on the trial court not to require any such evidence as to the motivation of the tipper – or perforce the knowledge of the tippees.
The decision in Newman has prompted the usual shock-shock from legal scholars and other critics since there is little doubt that the defendants apparently maintained networks of sources in such a way that they would never need to know the details of who said what or why. Thus, James Stewart has argued in the New York Times that Congress needs to enact a statute to replace the common-law case-by-case approach. As he points out, in the European Union it is simply illegal to trade on material nonpublic information irrespective of how one obtains it.[3]
To be sure, the Second Circuit seems to have gone out of its way to dress down both the prosecutor and the trial court for playing fast and loose with the law. But the real argument from the critics seems to be that if we know the defendants traded on material nonpublic information of the sort that must have come from an improper source, we should convict them – somehow.
The problem with this argument is that it is not per se illegal to trade on inside information in the United States. Rather, the information must have been disclosed improperly and the recipient tippee must (or should) know so. And there was zero evidence in Newman that the defendants knew that the tipped information had been improperly disclosed. Still, it is not completely clear that a prosecutor must prove a personal benefit (or gift) to get a conviction – although Newman now says so.
The law requires that the tipper violate a fiduciary duty by disclosing the information. What the Supreme Court said when it laid down the law in Dirks v. SEC was:
*** a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.[4]
Realistically, the Court allowed that it may not be easy to determine whether a tippee has breached a fiduciary duty to the source, since there are many situations in which confidential information may properly be disclosed even though the information is likely to affect the market. Thus, the Court went on to say:
Whether disclosure is a breach of duty therefore depends in large part on the purpose of the disclosure. *** Thus, the test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders.[5]
But the second sentence does not really follow from the first. It is black letter law that fiduciary duty comprises both a duty of loyalty and a duty of care. It is clearly contrary to the duty of loyalty to use corporate information for personal gain. But it is also a breach to disclose it negligently. Loose lips sink ships. So the idea that fiduciary duty is only about personal benefit misses half of the point.
To be sure, it may be difficult to show such a breach of fiduciary duty in the absence of a personal benefit. And it will certainly be difficult to show that a tippee knew of such a breach. But these are matters of proof – not the standard to be applied.[6]
In fairness, the Court’s opinion in Dirks must have been colored by the unusual facts in that case, where the tip relating to the massive insurance fraud by Equity Funding came from a whistleblower who sought to expose the fraud with the help of a prominent investment adviser who specialized in insurance stocks.[7] So there was little doubt that the tipper in Dirks acted for a proper purpose – even though the company presumably wanted to keep its fraud secret. So it turns out that easy cases make bad law too.
Moreover, Dirks is not the last word on the subject. The Supreme Court has subsequently suggested in United States v. O’Hagan that insider trading may be based on the personal use of material nonpublic information “in violation of some fiduciary, contractual, or similar obligation to the owner or rightful possessor of the information.” [8] And in the same case, the Court upheld SEC Rule 14e-3, which provides that nonpublic information about a planned tender offer may be presumed to be obtained in violation of a fiduciary duty (by someone) without the need to prove whom or how.
It is odd that the courts have not paid more attention to the question of the duty behind insider trading since it seems to arise with some regularity. For example, in SEC v. Dorozkho, the court declined to order seizure of the proceeds from insider trading based on information stolen by a hacker in Ukraine.[9] Remarkably, the court’s rationale was that Dorozkho had not breached any fiduciary duty in misappropriating the information. But is it not enough that everyone has a duty not to steal?
In SEC v. Cuban, the defendant Mark Cuban was a major (but not controlling) investor in a struggling internet search business.[10] The firm was in need of more capital and (in effect) decided to sell additional stock at a bargain price. Reckoning that Cuban might not be happy about the plan – because of the dilution he would suffer as a result – the CEO informed Cuban about the plan and offered him the opportunity to participate in it. Predictably, Cuban went ballistic. At the end of the call, Cuban told the CEO “Well, now I'm screwed. I can't sell.” Indeed, the CEO may have intended to tie Cuban’s hands with the tip. But reflecting on his situation -- and maybe after getting a little legal advice -- Cuban apparently realized that he could not be made a fiduciary against his own will. To be clear, a stockholder owes no fiduciary duty to fellow stockholders (except in some situations involving the exercise of control). And it was clearly a proper purpose for the CEO to discuss company plans with a major stockholder. So Cuban called back the CEO and declared that he intended to sell his shares before the deal was announced. And then he called the SEC to tell them what he had done!
The SEC was not amused and commenced an enforcement proceeding on the theory that information about the planned transaction had been disclosed to Cuban in confidence and subject (at least implicitly) to an agreement not to trade on it. The trial court dismissed the complaint because it was based on an agreement to keep the information confidential and not an agreement not to trade. After all, one can agree to keep a secret without agreeing not to trade on it. But the Fifth Circuit (per Judge Higginbotham) reversed, ruling that the confidentiality agreement could imply an agreement also not to trade depending on the totality of the circumstances. The case was remanded for further proceedings, but Cuban ultimately prevailed.[11]
Notably, the Fifth Circuit Cuban opinion does not once use the word fiduciary other than in quoting Dirks and O’Hagan. In the view of the Fifth Circuit, the case turns wholly on whether Cuban agreed not trade – and necessarily so since there is no real argument from fiduciary duty – thus tentatively breaking new legal ground albeit consistent with the suggestive language in O’Hagan.
On the other hand, fiduciary duty is often said to be a relationship of trust and confidence. So in Cuban, the SEC sought to rely on its own Rule 10b5-2, which states that a person has "a duty of trust and confidence" for purposes of misappropriation liability when that person "agrees to maintain information in confidence."
Nice try. But aside from the fact that Cuban was not a misappropriation case and that Cuban did not clearly agree to refrain from trading and that the rule conveniently omits the need for a fiduciary to agree to be bound – and not mention the circular reasoning – it is not clear that the SEC has the authority to rewrite the common law.
Entertaining as these cases may be (at least for those of us so easily amused), would it not be better for Congress to adopt a clearer rule like the EU standard that simply prohibits trading on material nonpublic information however it is obtained?
Hardly. The obvious problem with the EU approach is that it eliminates the incentive to look for such information. Why dig for gold if you cannot keep it when you find it?
To be sure, US law effectively invites the formation of so-called expert networks like those at work in Newman and described in a recent FRONTLINE program focusing on SAC Capital. By their nature, such networks may skate close to the edge of the law. But there is no reason to presume that they are designed primarily to provide cover for insider trading even if soldiers in the trenches predictably cross the line on occasion. Valuable inside information may often be disclosed gratuitously by a source who just wants to talk – or several such sources whose stories may be patched together. Ask any reporter or police detective. If a bribe happens we can deal with it when we find it. Indeed, if the ultimate problem is a breach of fiduciary duty, why not let companies deal with their faithless agents?
Moreover, someone must be the first to hear the latest market moving news. But a rule like the EU rule might arguably require traders to check to see if others have also heard the news before trading. In contrast, the US rule permits the market to get to the right price faster. And if fewer trades happen at the wrong price, investors are better off. Indeed, it is arguable that some insider trading is good for the market. Here (as elsewhere) the Europeans cleave to the precautionary principle. Better to throw the baby out with the bathwater if that is what it takes to eliminate insider trading. In the United States, we tend to think it better to ask forgiveness than permission.[12]
There is a real danger that the crusade against insider trading may render the market less efficient. In the US, about 80% of all stock is held by institutional investors in portfolios that turn over about 50% per year on average (and about a third of that is indexed with a turnover rate of less than 15% per year). Given that total turnover is about 150% marketwide, it appears that no more than 20% of investors account for most of the trading motivated by stock picking.[13]
In contrast, more than 60% of trading was so motivated in the 1960s when much of the law relating to insider trading (and other forms of securities fraud) began to coalesce. Moreover, finance scholars have suggested that because of the trend toward indexing, stock-picking may decline to as little as 11% of aggregate trading over the next decade.[14]
If so few investors seek to beat the market anyway, it is not clear why the government is so focused on insider trading enforcement. An investor who trades as little as possible and only for purposes of portfolio-balancing is equally likely to sell a mispriced stock as to buy one. For such an investor, insider trading by others comes out in the wash -- and without the baby. Other things equal, such an investor should prefer less enforcement – perhaps none at all – in exchange for a more efficient market.
So why do we spend anything at all to enforce the laws against insider trading? If most investors do not care about insider trading and would prefer more efficient markets to perfectly fair markets, who exactly benefits from enforcement? The answer must be that insider trading enforcement is intended to protect investors who seek to beat the market. But do stock-picking investors need protection? Will they give up if they think other investors may have an edge? And do we care? Most scholars of law and finance would likely agree that as a policy matter we should discourage investors from stock-picking since the chances of beating the market are no better than fifty-fifty. Thus, the cost of active trading is a deadweight loss that reduces return. The best strategy for most investors is to maximize diversification and minimize expenses by investing in an index fund.
Still, if everyone believed in the efficient market and stopped doing research, the market would no longer be efficient. Then even Jack Bogel – founder of Vanguard and champion of indexing – would become a day-trader. But this efficiency paradox is really no paradox at all. Traders will trade until the next dollar they spend on research – or inside information – brings in just another dollar of additional return. So there is no reason to think the market will slide back into inefficiency. If anything, it is the campaign against insider trading that has increased the risks for hedge fund investors and has falsely encouraged the small fry to swim with the sharks. We should let the market find its equilibrium.
Perfect fairness is not free. We should at least be clear about the cost.
[1] United States v. Newman, 2014 U.S. App. LEXIS (decided December 10, 2014).
[2] See Dirks v. SEC, 463 U.S. 646 (1983).
[3] See James B. Stewart, Business Day, Common Sense: Delving Into Morass of Insider Trading, New York Times, December 19, 2014, at B1.
[4] Dirks, 463 U.S. at 660.
[5] Dirks, 463 U.S. at 662.
[6] To be clear, the requirement is that the tippee has knowledge of the breach – scienter. But the breach itself need not be so supported by a finding of scienter. Moreover, as the Newman court noted, the prosecution must show willfulness on the part of the defendant in order to prove criminal culpability. See 1933 Act § 24; 1934 Act § 32. Although one might think that willfulness requires something more than mere scienter – for which recklessness may suffice – the caselaw is far from clear in part because scienter is a judge-made requirement borrowed from the common law of intentional torts. It does not appear anywhere in the statute.
[7] Indeed, the Dodd Frank Act now provides for rewards to whistleblowers in just such situations – though it would still be illegal for the tipper herself to trade on the information for personal gain. Go figure.
[8] United States v. O’Hagan, 521 U.S. 642 (1997).
[9] SEC v. Dorozhko, 2008 U.S. Dist. LEXIS 1730 (S.D.N.Y. 2008).
[10] SEC v. Cuban, 620 F.3d 551 (5th Cir. 2010).
[11] See John Carreyrou, Cuban Is Cleared By Jury, Wall Street Journal, October 17, 2013 at C1.
[12] It is somewhat ironic that Newman was decided within days of the death of Dean Henry Manne who made a career out of pointing out the contradictions inherent in the law against insider trading. See See A Champion of Law Informed by Economics, Wall Street Journal, January 20, 2015 at A13 (excerpting Manne opeds); Henry G. Manne, Busting Insider Trading: As Pointless as Prohibition, Wall Street Journal, April 29, 2014 at A15.
[13] To be precise, about 35% of volume is attributable collectively to program trading, market-making, and issuer repurchases. If the 80% of stock held by well-diversified institutions turns over 50% of the time, that accounts for about 40% of all trading – for a total 75% of turnover. So roughly speaking about 20% of all stock accounts for the remaining turnover of about 75% that is attributable to efforts to beat the market. See generally Richard A. Booth, The Buzzard Was Their Friend – Hedge Funds and the Problem of Overvalued Equity, 10 U. Penn. J. Bus. & Emp. L. 879 (2008). http://ssrn.com/abstract=2220180
[14] See Utpal Bhattacharya & Neal Galpin, The Global Rise of the Value-Weighted Portfolio, 46 J. Fin. Quant. Anal. 737. http://ssrn.com/abstract=1527467. See also Mark Hulbert, Maybe the Stock Pickers Have Gone Fishing, New York Times, January 1, 2006; Economics Focus, Passive Aggression: America's Shareholders Settle for Guaranteed Mediocrity, The Economist, January 26, 2006. Moreover, Bhattacharya & Galpin note that stock-picking is more common in less developed markets, although they speculate that this may be attributable to lack of regulation.
Recent Comments