Insider Trading or Legitimate Market Research?

Market research by analysts and professional investors makes important contributions to the capital markets by promoting the liquidity and efficiency of those markets. As Professors Gilson and Kraakman explain, there are four principal mechanisms by which markets process information and set equilibrium prices in response to new information:

First, market prices immediately reflect information that all traders know, simply because this information necessarily informs all trades, just as perfect markets theorists assumed (“universally-informed trading”). Second,information that is less widely known but nonetheless public, is incorporated into share prices almost as rapidly as information know to everyone through the trading of savvy professionals (“professionally-informed trading”). Third, inside information known to only a very few traders would find its way into prices more slowly, as uninformed traders learned about its content by observing tell-tale shifts in the activity of presumptively informed traders or unusual price and volume movements (“derivatively-informed trading”). Finally,information known to no one might be reflected, albeit slowly and imperfectly, in share prices that aggregated the forecasts of numerous market participants with heterogeneous information (“uninformed trading”).

Take away the ability of professional investors and analysts to ferret out information and we weaken both the professionally-informed trading and the derivatively-informed trading mechanisms. The result will be less liquid markets with greater price anomalies.

The late US Supreme Court Justice Lewis Powell was aware of the valuable contributions market research makes and deeply concerned that an over expansive prohibition of insider trading would deter legitimate market research. Hence, he wrote in Dirks v. SEC, 463 U.S. 646 (1983), that:

Imposing [insider trading liability] solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market. [Footnote 17] It is commonplace for analysts to "ferret out and analyze information," 21 S.E.C. Docket at 1406, and this often is done by meeting with and questioning corporate officers and others who are insiders. And information that the analysts obtain normally may be the basis for judgments as to the market worth of a corporation's securities. The analyst's judgment in this respect is made available in market letters or otherwise to clients of the firm. It is the nature of this type of information, and indeed of the markets themselves, that such information cannot be made simultaneously available to all of the corporation's stockholders or the public generally.

[Footnote 17] The SEC expressly recognized that "[t]he value to the entire market of [analysts'] efforts cannot be gainsaid; market efficiency in pricing is significantly enhanced by [their] initiatives to ferret out and analyze information, and thus the analyst's work redounds to the benefit of all investors." 21 S.E.C. Docket at 1406. The SEC asserts that analysts remain free to obtain from management corporate information for purposes of "filling in the interstices in analysis'. . . ." Brief for Respondent 42 (quoting Investors Management Co., 44 S.E.C. at 646). But this rule is inherently imprecise, and imprecision prevents parties from ordering their actions in accord with legal requirements. Unless the parties have some guidance as to where the line is between permissible and impermissible disclosures and uses, neither corporate insiders nor analysts can be sure when the line is crossed. Cf. Adler v. Klawans, 267 F.2d 840, 845 (CA2 1959) (Burger, J., sitting by designation).

Accordingly, the Dirks case confirmed the basic principle that insider trading liability does not arise simply because the defendant had more information than other market actors. Instead, liability arises only when the defendant breached a fiduciary duty by trading on the basis of that information or by tipping the information to a corporate outsider (I oversimplify somewhat). See generally my book Securities Law: Insider Trading (Turning Point Series). Hence:

"Just saying, we want better information, even we want information no one else has, there's absolutely nothing illegal about that," said Christopher Clark, a former federal prosecutor who is now a defense lawyer. "The only illegality is when it comes in breach of a fiduciary duty or in another similar duty that requires them not to use the information."

As I document in my Insider Trading text, the SEC hates the Dirks rule. The SEC has always wanted a rule of equality of access: If you have more information than anybody else, you can't trade. The SEC has consistently by rule and by positions it takes in litigation sought to undermine the Dirks regime. As Peter Wallison observed, for example, this attitude drove the adoption of Reg FD:

Over the years, the SEC has been pursuing the idea that it is inherently unfair when one party to a securities trade has more information than another. The prime example of this is Regulation FD, initially proposed under the chairmanship of Arthur Levitt in 2000, which attempted to ensure that companies do not provide material information to analysts unless that information is made public at the same time.

Wallison contrasts the SEC's position to that of Justice Powell, explaining that:

... there is also an important idea implicit in the Court’s statement that “it is the nature of this type of information” that it “cannot be made simultaneously available to all the corporation’s stockholders or the public generally.” The Court’s point was that the information would have no value to the analyst, and hence would not be collected, if it had to be made public before it could be used. In other words, the Court recognized that incentives are necessary to ensure that information gets into the market. In effect, the Supreme Court in 1983 was drawing a fine line between two competing values. On one side was the notion that corporate insiders should be punished for violating their fiduciary obligations to the company or its shareholders by disclosing inside information improperly. But on the other side was a desire to ensure--through appropriate incentives--that important information gets into the market and affects the market price of shares for the benefit of all investors.

The SEC’s approach is quite different. ... [The] agency focuses on the inequality of information between the informed and the uninformed traders at the moment of the trade. This approach naturally devalues incentives to supply information to the market, and in the end prefers a market in which both sides of a trade are equally ignorant rather than a market in which one trader profits at the expense of another.

It is precisely this set of concerns that is implicated by the so-called Galleon insider trading case. It may be that Raj Rajaratnam got information via tips from people who thereby breached a fiduciary duty they owed to the source of the information. But did Rajaratnam know they were doing so? Can the SEC prove not just that Rajaratnam had better access to information than the market generally, but that he got that information by being a participant after the fact in the tipper's breach of fiduciary duty?

There is a very serious risk that this case could chill aggressive but legitimate research by hedge funds and other professional investors. If so, the SEC will have done a serious disservice to the ordinary investors it claims to be protecting. Those investors will be left with a less efficient and less liquid market.

These concerns are particularly pronounced because, as the WSJ reported, this is not a one off case:

The investigation comes as the SEC has been increasing its focus on hedge funds and has ramped up surveillance to look for patterns and trends in trading. Over two years ago, the SEC expanded its focus beyond looking solely at individual stocks that had suspicious trading patterns. The agency put in place a new computer system that looks for traders who pop up repeatedly in insider-trading referrals, people familiar with the matter said.

All of which raises an age-old question: Quis custodiet ipsos custodes?

Comments

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As a lawyer and a former derivatives market maker on both the American Stock Exchange and the Chicago Board Options Exchange, I find the legal community's thoughts on trading in general to be so out of touch with the realities of trading as to be nearly worthless. Perhaps the best example of the entire profession's (excluding the SEC's) lack of understanding at a fundamental level is the fact that this article relies on analysis of from an opinion written in 1983. To think that the learned Justice Powell's reasoning is even remotely applicable today, given the velocity of information and the widespread availability of the important raw data related to a particular company's finances and general business position, is absurd.

Your argument is similar to those that think we still need Specialists on the floor to "facilitate" the markets and provide liquidity. I can tell you first hand, that market makers are simply not needed in "deep" markets. They just get in the way. We used to make a fortune by virtue of our position as "referees" on the floor. Then the internet came and made us obsolete because buyers and sellers could find each other, manage their orders quickly, and trade with each other efficiently. That was the end of widespread profitability in floor marketmaking for options, and it occurred in 2002. When the market realized that market makers were just friction (think of the rake in a poker game), they changed the rules and effectively dumped us. Spreads are now tighter, markets are deeper than ever, and customers get better execution as a result.

Applying this to the "need for analysts" debate should be enlightening. Justice Powell thinks that I need an Analyst to tell me about significant inside information, like, for example, if Capital One is experiencing higher defaults than in a previous quarter. Obviously this isn't good and will cause net income to shrink. Why can't I just get it straight from the horse's mouth? Justice Powell's position is that I need the Analyst to figure out what is important and what is not. This just puts an arbitrary and unnecessary middleman in the picture. The Analyst then takes this information, gives it to its clients early, and the rest of the market is left out in the cold, and loses money as a result. The Analyst is the rake.

Information flows fast today, and raw data is easily digested by everyday investors. Furthermore, the common man has his money in a pension fund or 401k managed by a so-called "professional." None of these people need analysts to tell them what is important to a stock. Allowing someone to get the raw data first, digest it, and then disseminate it to their clients for trading purposes is cheating, plain and simple. It is unfair, and people who do it should go to jail. The free flow of information is what makes capital markets efficient, not the other way around.
We need to update our thinking to reflect the realities of the market. Anyone who thinks that investment banks make a lot of money because they are the sages of all that is trading needs only to look at how pretty much every one of them dropped the ball on the mortgage meltdown. They can't identify a long term trend if it bit them in the face. They aren't any smarter or more capable of processing information; they simply have more of it to trade on during the short term than the average Joe. That isn't right. To think that liquidity will dry up if analysts are taken out of the picture is ridiculous. Our capital markets are global. Smart money is abound. Therefore, no one should get a jump on information. We are all financially equal either through our own savvy or the money manager who we have hired to represent our interests. Therefore, insider trading should be illegal. The SEC has it right.

[Richard W. Painter]

This is an excellent post. Professor Bainbridge is one of the relatively few people who really understands insider trading law, to the extent it is possible to understand insider trading law.

I am as concerned as anybody about illegal insider trading by hedge funds and others. I am also concerned about the great lack of clarity in this area of the law -- a topic I and two coauthors raised after the O'Hagan case in a law review article -- "Don't Ask, Just Tell: Insider Trading After United States v. O'Hagan" 84 Virginia Law Review (1998). Eleven years later there is still insufficient clarity here. One should not have to have Professor Bainbridge on call to avoid running afoul of a criminal statute. Its time for Congress to do something about this when they get finished with health care and with regulating just about everything else in the ecomony.

Richard Painter

[MDF]

On the Reg FD point, wasn't the main objective not so much making the info public, but making the info available to all equity analysts simultaneously, as a way to prevent blackballing? (As a drafting point, you'd require that it be made available "to the public" because it would be hard to define what an "analyst" is and you don't want any loopholes.) After all, you could make the policy judgment that the threat to the market of blackballing an analyst who publishes a negative assessment of an issuer outweighs the risk that less information be introduced to the market, since the effects of blackballing could be quite pernicious.

[L]

The flip side to the first commentor's argument is that all insider trading should be legal. This practice would disseminate information to the market much more rapidly, again eliminating the analysts as middlemen. Information that the company leadership did not want to make public, because it would reflect badly on their performance, would still affect the stock price as employees traded on it. That in turn would affect the stock price, and thereby cause it to better reflect its true value. That, in turn, would allow information to trickle out in real time, instead of being released when it best reflects upon company management.