THE QUANT by Richard Booth

THERE OUGHTA BE A LAW. OR MAYBE NOT.

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.

 

 

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[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.

 

 

HENRY FORD AND THE GOOGLE GUYS

The pronouncement by one of the Google Guys that the company is not run for the long term value of the stockholders but rather for the long term value of the end users, is reminiscent of Henry Ford's decision in 1916 to stop paying dividends in order to improve the lot of workers and customers. Or is it? There are a couple of big differences.

First, Ford admitted that the company had a pile of cash that it did not need for any business purpose. The Michigan Supreme Court ordered him to distribute it as a dividend and the Dodge Brothers (who owned 10 percent of Ford) used the money to start their own car company. The court also said that Ford's decision to use an even bigger chunk of change to lower prices and to build housing for workers was OK too under the business judgment rule. Who were they to say that happy workers and lower prices were not the best way to maximize profits? So the case supports the proposition that the stockholders own the company and that management can manage virtually without interference. King Solomon would have been proud.

Second – and this is a big difference – most stock today is held by highly diversified investors through mutual funds, pension plans, and the like. Diversified investors prefer individual portfolio companies to maximize value (however that might be measured). But they do not want portfolio companies that try to coddle investors by reducing risk by managing earnings, diversifying through acquisitions, hedging, and other such gimmicks. Investor diversification deals with all that – and for free. So it is a waste of investor money for portfolio companies to do it too. The bottom line is that companies that stick to their knitting – focus on their core business – and do not try to second guess the market. See Stockholders, Stakeholders, and Bagholders (Or How Investor Diversification Affects Fiduciary Duty).

Google has shown itself to be more in tune with such thinking than most companies. A few months back one of the Google Guys announced that the company would make no effort to smooth out earnings. For an undiversified investor like the Dodge Boys, it could be a bumpy ride. But for a mutual fund investor it all evens out. Well diversified investors like those that invest through mutual funds should cheer.

By the way, managers who are willing to give the market what it really wants – a focused company that seeks to do what it does best – assume more risk than managers who seek to manage earnings. They should be compensated accordingly. Thus, it is really no surprise that CEO pay seems to have risen in recent years. I say seems because aggregate executive pay as a percent of earnings has been remarkably flat since 1980. But I do suspect that more of it goes to CEOs than before. See Executive Compensation, Corporate Governance, and the Partner-Manager.

The takeover wars of the 1980s were all about breaking up idiotic conglomerates and rationalizing capital structures. Stock prices went up. Folks figured out what the market wanted. CEOs began to insist on a piece of the (risky) action. Stock options became the norm.

I am sure that stock options can be and have been abused. And we should deal harshly with those who manipulate things in order to cash in at the expense of stockholders. But let's not lose sight of the fact that it is now quite routine for managers (and even major stockholders) to voluntarily break up their companies when it makes economic sense to do so, because the market likes focus. Is this a great country or what?

Thanks to Securities Litigation Watch for a heads up on this story.

A FURTHER NOTE ON KIRCHER (AND MUTUAL FUND LITIGATION IN GENERAL)

No one will be surprised if the Supreme Court affirms Kircher (thus permitting Judge Easterbrook's opinion to stand). The plaintiff fundholders will thus be left without a remedy, because as holders they have no cause of action under federal law. The losses they suffered in the value of their fund shares because of abusive trading at the fund level will become permanent. Note that this is not a case like a conventional securities fraud case in which the value of the fund shares would have fallen anyway when the truth came out. Here, the value fell because insiders were permitted to trade in fund shares. Innocent fund holders saw NAV fall bit by bit but only later found out why. In other words, the harm was real and not just a matter of a market correction.

The good news is that the plaintiffs may still have a cause of action (though it may now be barred by the statute of limitations).

First, they could sue derivatively on behalf of the fund. After all the fund was a party to the abusive trading in fund shares. So the fund clearly has standing under federal law. One problem is that the plaintiff must make a demand on the board of directors of the fund to sue the culprits. The board will likely refuse, but it is unclear that such a decision would be upheld even under the business judgment rule. Another problem is that in a derivative action the fund should ordinarily recover. That might lead to speculative trading in fund shares. (Outsiders might buy into the fund seeking a share of the recovery which would presumably be added to NAV at some point.) That could be avoided by individual recovery. But the courts are reluctant to order individual recovery.

Second, the plaintiffs could file a class action for equitable relief under FRCP 23(b)(2). Presumably, the reason they sued in state court in the first place was that they knew (or worried) that they could not maintain a class action in federal court because they were mere holders. But suppose they filed an action against the fund seeking to compel the fund to sue the culprits and to distribute the proceeds (if any) by issuing new shares to members of the class. (That would avoid the problem of speculation in fund shares by soaking up the recovery.) To be sure, this procedure looks a lot like a derivative action, but for the bit about issuing new shares to the class members. But so what?

For a fuller discussion, see How to Compensate Mutual Fund Investors for Late Trading and Market Timing.

TO HAVE AND TO HOLD (AND PERHAPS TO RECOVER DAMAGES)

To hold or to fold? That is the question. The stakes are high in two securities fraud cases pending in the Supreme Court. Both involve plaintiffs who suffered losses as a result of holding onto shares that later fell in value. Under federal securities law, a claim of fraud must be in connection with the purchase or sale of securities. So these plaintiffs sued under state law. But since 1998 federal law has also required that any class action based on allegations of fraud in connection with a purchase or sale must be litigated in federal court. (The worry was that plaintiffs had begun to sue in state court as a result of 1995 federal legislation designed to prevent abusive securities fraud class actions.) To be sure, there were a few fewer such cases filed last year: 176 compared to 213 in 2004. But as the Wall Street Journal recently opined, it is remarkable that plaintiff's lawyers could find that many cases to file in a time of such flat markets. The one factor that may account for such action in market for litigation is the Sarbanes Oxley Act, which coincidentally gives holders new grounds for griping.

In 1975, the Supreme Court handed down Blue Chip Stamps, holding that a prospective purchaser of stock who had been persuaded not to buy had no standing to sue for damages when the stock later increased dramatically in price. The case became a landmark, not only because it came to stand for the purchase or sale requirement, but also because it signaled the beginning of the Court's checkered campaign to limit the reach of federal securities law as a basis for private actions for damages. In 2002, the Court loosened up a bit but reaffirmed the rule in SEC v. Zandford, upholding an action against a broker who sold customer securities and then stole the money. 

The Supreme Court recently heard oral argument in Dabit v. Merrill Lynch, in which the Second Circuit held that a claim by investors who were fraudulently induced to hold shares could proceed under state law. (It will likely hear that argument again now that Justice Alito has joined the court.)

The Court has also agreed to hear an appeal in Kircher v. Putnam Funds, in which the Seventh Circuit dismissed an action by holders of mutual fund shares who claimed that the value of their shares was reduced by abusive trading schemes that fund managers should have blocked.

It is usually a good bet that the Court takes a case in order to reverse it. But Dabit and Kircher are more or less polar opposites. The better bet would seem to be that the Court is likely to retreat from the somewhat expansive holding in Zandford and to side with the Seventh Circuit in Kircher.

That would be unfortunate. In Kircher, mutual fund investors saw their shares decline in value because of abusive trading by others in fund shares.

Clearly the fraud was in connection with those trades. As in Zandford, the net effect was as if shares has been stolen from investor accounts. Still, the plaintiff investors did not themselves trade.

Dabit is a case based on fraudulent investment advice coming from a broker. The argument is that the plaintiff class was induced to hold when it would have sold.

Some might argue that holders are different from the non-purchasers in Blue Chip Stamps. After all, holders once bought. They put their money where their mouth was. As they say on Wall Street, every hold is a buy. And indeed Judge Motz of the federal district court in

Baltimore

so held in a case very like Kircher, noting that Blue Chip Stamps is a judicial rule of convenience for a judicially created cause of action.

But there are dangers lurking in recognizing the claims of holders. Dabit could easily have made his claim against a company that issued a falsely optimistic press release, suing the company for losses suffered by all non-trading holders. If successful, the company would presumably be ordered to compensate holders for their losses. But what good would that do? For every dollar a holder gets in damages the company would decline in value by a dollar. What's the point? And incidentally, if we had a system in which holders could sue for compensation, the market would presumably react by discounting the stock price of a target company stock by the amount of the likely award, which would increase the award, and lead to a further discount in the price until -- guess what -- the stock is worth zip. It is the financial equivalent of a black hole.

On the other hand, holders are the real losers in the typical securities fraud class action. Buyers (or sellers in some cases) can sue. But the company ultimately pays. It is holders who lose. Indeed, in the typical case involving negative news that causes the price of defendant company stock to fall, holders suffer a triple whammy. They lose because the price falls. They lose because the company pays the damages (which causes the price to fall even more). And they lose because the litigation costs the company a small fortune in attorney fees. (Ironically, buyers and sellers come out about even over time because they never need to give back their gains when they are on the winning side of a trade.)

It would seem only fair to let holders recover. But it is mathematically impossible to make them whole.

The answer is to junk the system that permits securities fraud class actions by aggrieved investors. Claims based on the notion that one bought or sold stock at the wrong price should be summarily dismissed. For diversified investors, such claims come out in the wash anyway. Their only net effect, other than to generate hefty attorney fees, is leave holders worse off. In other words, we can fix things for holders by eliminating securities fraud class actions by which holders end up footing the bill for traders. That would let the loss lie where it falls with those best able to bear it through diversification. And it would end the effective subsidy that the system provides for stock pickers who persist in trying to beat the house in a world of efficient markets.

The situation in Kircher is different. There the claim is not one based on having bought or sold or held stock because an investor was fooled about the price. Rather the claim is one of simple (or not so simple) theft by something similar to insider trading. Moreover, the plaintiffs can be made whole if the culprits simply disgorge their ill gotten gains back to the fund. It is not a matter of taking money out of one pocket and putting it in another.

To be sure, the claim in Dabit is also against a third party. It is not a conventional class action against an issuer. But it is difficult to see how the courts permit an action by holders against a broker and not an action directly against an issuer. This is not to suggest that Dabit somehow should have had a federal claim. Dabit's claim is under state law. But it is still a direct claim for damages -- not unjust enrichment. So it is difficult to imagine that if Dabit is upheld holders will not have a claim against issuers in future cases.

The Court would be right to reverse Dabit and nip this trend in the bud. That is not to say that holders are not entitled to truthful information. Indeed, shortly after SLUSA was enacted, the Delaware Supreme Court ruled that stockholders can sue when management knowingly spreads false information. But to do so they must show that the corporation was harmed. And recovery must go to the corporation. In other words, the claim must be one against directors, officers, or agents of the corporation -- not the corporation itself. In contrast, Dabit is a claim directly by investors who want compensation so they can live to trade another day.

There is another important difference between Dabit and Kircher. The plaintiffs in Kircher are mutual fund investors who presumably value diversification and conservative professional management and have eschewed a life of stock picking and active trading. Ironically, during oral argument, Dabit's lawyer disingenuously portrayed his clients as subscribing to the street wisdom of buy-and-hold. At least they happened to be holding when the music stopped in this case. The Kircher plaintiffs did the rational thing and got screwed. All they want is their money back. They should get it.

WHY IS INSIDER TRADING ILLEGAL?

A recent item in the The Ethicist (New York Times Sunday Magazine, 1/22/06) resulted in a flurry of postings about why insider trading is wrong. See, e.g., Thom Lambert, Correcting “The Ethicist” on Insider Trading.

It has never been entirely clear why insider trading is illegal. The insider does not cause the outsider to trade at just the wrong time. The insider simply takes advantage of the fact that an outsider is always there to take the other side of the trade.

So the courts have resorted to theories based on the duty owed by the insider either to the corporation and its stockholders or to the source of the information not to use the information for personal gain. The problem is that if the corporation or the source gives permission to use the information, there would seem to be no reason for insider trading to be illegal. Yet no one has been so bold as to test the theory.

One might also argue under the fraud on the market theory that outsiders rely on the accuracy of the market. But that argument proves too much. It suggests that outsiders should be able to recover whenever insiders fail to correct the market.

There is another possibility. Most investors are well diversified. They do not care whether the market price is somewhat high or somewhat low when they trade as long as insiders do not use the opportunity to trade. As far as a diversified investor is concerned, you win some, and you lose some, but only the average matters. If insiders can trade at will when they know the price is wrong, the math no longer works, and there is no safety in numbers for outsiders.

So here is the theory: Insider trading is illegal because publicly traded companies and their directors, officers, and agents have effectively made a deal with outsiders (the market) not to take advantage of the situation when they know prices are wrong. Why? Because the most important reason for being a publicly traded company is not that you once raised a pile of money from an IPO, but rather that you might want to go back to the market for more, or pay your help with options, or just cash out some day. To sort of paraphrase Ed Koch and Ryan O'Neal: When you are publicly traded you never need to ask how you are doing.

THE END OF THE SECURITIES FRAUD CLASS ACTION AS WE KNOW IT

In the typical securities fraud class action (SFCA), the subject company either delays the disclosure of bad news or issues an unduly rosy press release. Either way, investors who buy during the fraud period pay too much. When the truth comes out, stock price falls. The investors then sue the company (and maybe the accountants or other agents) for the difference between what they paid and what their shares turn out to be worth.

As many legal scholars have noted, stockholders who sell during the fraud period effectively capture a gain equal to the amount of the loss to those who buy. In other words, securities fraud is a zero sum game. But the sellers are not required to reimburse the buyers. Rather, the company pays. But that means that the price of the company stock will fall still further -- sometimes by much more than it would have fallen but for the threat of litigation. In any event, the real losers are long term stockholders who did not trade during the fraud period. This system of supposed investor protection makes no sense at all. It penalizes rational buy and hold investors and rewards active traders.

If investors could get together and talk it over, they would likely agree to stop this insanity. Individual investors would realize that over time they are equally likely to be a seller/gainer as a buyer/loser. Gains and losses will net out. But the cost of litigating securities fraud is a deadweight loss to the system.

There is one big exception. If insiders sell during the fraud period, they change the odds. Innocent outside investors will realize more losses than gains. So they would want a remedy in such cases. But they would not want the remedy to require the company to make good on their losses. That would cause a further decline in stock price to the detriment of those who did not trade during the fraud period. Rather, it would be enough for the trading insiders to give up their gains to the company. That would have the effect of increasing the value of the company by just enough to rebalance gains and losses for outsiders.

There is a really simple way to achieve this solution. Instead of using a class action in which investors are the members of the plaintiff class and seek recovery individually, securities fraud should be litigated in the name of the company, and the company should recover from the insiders who extracted wealth from the market. If the company refuses to sue, then a stockholder can file a derivative action in the name of the company. Moreover, the courts have the power to decide whether an action is a direct class action or a derivative action in which the company is the true plaintiff. So the courts can fix the problem on their own motion if necessary.

As you might guess, I have a written a full-blown article on this subject:

WHO SHOULD RECOVER WHAT IN A SECURITIES FRAUD CLASS ACTION?