ProfessorBainbridge.com

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An Old Debate Reprised: Should Insider Trading Be a Federal Crime? Wall Street Journal ... who writes regularly at Truth on the Market, and UCLA's Stephen Bainbridge, who maintains his own blog at ProfessorBainbridge.com. ...

The Government's Insane War Against Insider Trading CNBC The only sensible argument I've found by someone claiming that insider trading has a victim is made by Stephen Bainbridge, who says that some insider ...

Round 2 on the TSA Backlash Mother Jones Stephen Bainbridge: Everybody knows El Al security includes racial and ethnic profiling. So we can't use it in the USA because profiling would violate the ...

Why I don't like Mitt Romney

In the comments to a recent post, Adam asked:

Why do you dislike Mitt Romney?

I could mention his flip flopping on the issues, especially abortion. I could mention RomneyCare. I could remind you of the time he said his sons were serving their country by working for his campaign. Or his draft dodging. I could agree with something John Cole said: "He is so completely phony, so calculated and poll-tested and focus-grouped and rehearsed and plastic and totally full of shit. There is no emotion in his words, it is like an automaton spitting out the right ‘crafted’ response. Sometimes he uses the wrong words- “loss” instead of “lose,” and it sounds like a robot that was programmed incorrectly, or someone using English as a second language. Not someone just making a verbal gaffe."

I could mention a lot of other things, but let's just leave it at this:

Memo to John Carney re The SEC Exception to the First Amendment

John Carney spotted an interesting episode in which Bloomberg was the first with information that Janus was the subject of the ongoing SEC insider trading probe:

That information wasn’t publicly available to anyone who does not have a Bloomberg terminal. It wasn’t posted on Janus’s website. In fact, it took several minutes before it appeared in any place the general public has access to.

So is Bloomberg aiding insider trading? Of course not. It’s a journalistic enterprise whose right to report information is protected by the First Amendment. That’s true even if the information is ‘non-public’ and has obviously been leaked by an insider. And, although it’s less clearly spelled out in the constitution, the right to gate the information so that it is only available to subscribers is probably protected as well.

Bloomberg probably didn't commit insider trading because it breached no fiduciary duties in disseminating the information and, I assume, neither did their tipster. Although the SEC would like to change that rule, it remains the law of the land.

What John overlooks, in any case, is the <SARCASM>little known SEC exemption to the First Amendment</SARCASM>. The SEC has repeatedly run roughshod over speech protections. It has tried to get prior restraints against people who put out investment newsletters without registering under the 40 Act. It has argued that newspaper ads are proxy solicitations. It compels speech by mandating disclosures. The shareholder proxy rule compels the company to let some self-appointed yahoo put a proposal and supporting statement in the company's proxy statement. The proxy access rule compels speech by requiring the company to include shareholder board nominees in the proxy statement. The SEC has argued that newspapers owe fiduciary duties to the readers in connection with insider trading cases.

As far as the SEC is concerned, there is a tiny footnote to the First Amendment that says "The SEC is exempt herefrom." Unfortunately, it's been all too rare for courts to spank them.

Interviewed Lots of Places re Insider Trading and etc.

The hazy line between legal market analysis and insider trading Marketplace Tess Vigeland talks to UCLA law professor Stephen Bainbridge. ... But we've called Stephen Bainbridge, he teaches law at the University of California, ...

This Week in Small Business: Flying Pigs and Lame Ducks New York Times Stephen Bainbridge makes his attempt to fix things. James Pethokoukis, of Reuters, tells us that the deficit problem is a spending problem and is happy the ...

Preet Bharara's Arms Race Theory of Insider Trading CNBC ... that we punish other forms of theft of property,” writes Stephen Bainbridge, UCLA law professor and author of “The Law and Economics of Insider Trading. ...

Why Insider Trading is Here to Stay BNET As corporate law professor Stephen Bainbridge notes, insider trading amounts to theft, usually of information. And while there's debate over to what extent ...

Interviewed by NPR Marketplace re the Expert Network Insider Trading Case (Updated w/ transcript)

I was interviewed today by NPR's Marketplace. The interview is in the first segment of the current episode.

Update: Here's a permalink to the segment and a transcript of the interview.

Why practicing lawyers ought to hate legal academics

Bridget Crawford:

I don't know that lawyers do hate law professors, but if I had to guess, I'd say that most practicing lawyers don't think too highly of legal academics as a group.

But why? She speculates "that economic constriction [might] lead to anti-faculty sentiment."

Look. The disconnect between the practicing bar and the legal academy is hardly a new problem. And the reasons are well known:

1. Law schools produce too many students who can't write a coherent letter, let alone a detailed contract or brief. Inside Higher Ed reports: "The 2008 annual results of the Law School Survey of Student Engagement, released today, show nearly half of all law school students reporting that their education does not “contribute substantially” to their ability to “apply legal writing skills” in the real world."
2. It's bad enough that courses like "Law and the Visual Arts" or "Law and the Evils of Republican White Male Hegemony" don't prepare students for practice, but neither do most "core" courses.  The ABA reports: "Now a recent report by the Carnegie Foundation for the Advancement of Teaching, Educating Lawyers: Preparation for the Profession of Law, reports that while some improvements have been made, legal education still pays little attention to training students in how to actually practice."
3. Legal scholarship is increasingly irrelevant to judges and lawyers. Judge Harry Edwards once described what I think is the right goal of legal scholarship: "a good 'practical' scholar gives due weight to cases, statutes and other authoritative texts, but also employs theory to criticize doctrine, to resolve problems that doctrine leaves open, and to propose changes in the law or in systems of justice. Ideally, the 'practical' scholar always integrates theory with doctrine." Today, however, too many professors focus solely on theory. They write articles about how the study of Icelandic blood feud sagas open new ways for wise neo-Marxist Latinas to use critical feminist theory to expose the hegemony of fat white guys in law school cafeteria lines. And it gets worse as law schools hire more and more PhDs. We increasingly see people with mediocre law school records who lack experience as a law clerk or practicing lawyer getting hired because they're ABD on some project involving multiple regressions and best buddies with the ABD rookie we hired last year. For these folks, if they can't count it, it doesn't exist. And then there's the GIGO problem. A while back I mentioned having read a paper "on executive compensation, whose author should remain nameless. The author found a statistically significant result that he didn't like. So he threw it under the bus by claiming that his regressions were flawed. Accordingly, he turned to panel data analyses that gave him a result he liked. All the while, another paper on the same topic had found the same results as our author's regressions. Who was it that said statistics don't lie?" And don't get me started on their inability to actually analyze traditional legal sources. It's no wonder the NY Times was able to report that “I haven’t opened up a law review in years,” said Chief Judge Dennis G. Jacobs of the federal appeals court in New York. “No one speaks of them. No one relies on them.”

It's almost enough to tempt me to try my hand at being a dean at a law school that wants to try a different approach. Almost. But then I remember one of my favorite Reaganisms -- "It's true hard work never killed anybody, but I figure, why take the chance?" -- and come to my senses.

A very dear colleague of mine back when I was at Illinois described being a law professor as a "loophole on life" and compared it to the job of a dean which is "being a fire hydrant in a room full of dogs with urinary incontinence." I think I stick to the former.

Those Darned Austrians

Austrian economists taking over the GOP?

As David Frum has noted, Austrian economists are awfully popular among Republicans.  It’s an odd phenomenon: many of the world’s most influential economists are conservatives, but none of them are Austrians.  And instead of embracing the most brilliant economists in the world, Republicans lift talking points from a group at the margins of modern economics.

At a superficial level, Austrians are influential because they’re so damn loud.  Ever listened to conservative talk radio or watched Beck’s TV program?  Chances are you’ve listened to an Austrian economist, probably one predicting impending economic apocalypse.  As an occasional contributor to FrumForum, I learned quickly that Austrian economics posts invite an army of e-critics.  (This piece will likely inspire an essay-length comment and about 84 links to articles on mises.org.)  But there’s something else going on.  Austrians aren’t just the most vocal and inspired advocates of capitalism; these days they often seem like capitalism’s only friends.

But what is Austrian Economics? Thom Lambert recently discussed it:

A hallmark of Austrian thinking, especially as articulated by F.A. Hayek, is the notion that the information required to allocate productive resources to their highest and best ends, and thereby to maximize wealth, is not readily available to any individual or central authority. Instead, it is widely dispersed among individuals throughout society. Accordingly, attempts to maximize value by allocating productive resources in a centralized fashion — i.e., according to the dictates of central planners — are destined to fail. Those planners lack access to important information (most notably, information about how individual consumers value competing uses of productive resources) and could not effectively process all that information, much of which is conflicting, even if it were accessible.

But, say the Austrians, there’s no need to despair. In a society with well-defined, freely transferable property rights, the impossibility of effective central planning presents little problem. As individuals engage in trades in an attempt to better themselves, prices for productive resources will emerge. Those prices incorporate all available information about the relative value of competing uses of a productive resource (i.e., the person willing to pay the highest price for something will create the most value from it and should possess it if the goal is to maximize wealth). They present that information in a simple, useful form (i.e., one need not worry about calculating the net effect of conflicting bits of information about a resource’s highest and best use; the price mechanism will do so). And they motivate economic actors to take precisely the steps that will maximize total wealth (i.e., relatively high prices for a resource induce producers to make more of it and consumers to substitute away from it; relatively low prices induce less production and more consumption of the resource). Thus, when property rights are well-defined and freely transferable, prices will create a spontaneous order that trumps anything achievable using central planning. ...

I should note one other Austrian (specifically, Hayekian) distinction, this one between types of legal rules.  Some legal rules are general in their application, are “purpose-independent” (meaning that the law-giver isn’t trying to achieve some specific social outcome but is instead trying to resolve a dispute in accordance with the parties’ settled expectations), and have the effect of setting clear expectations so that parties may confidently predict outcomes in structuring their affairs.  Hayek refers to these sorts of rules as nomos.  Other legal rules are more akin to specific orders from a central authority seeking to achieve some specific purpose.  Such “teleological” rules Hayek refers to as thesis. 

In light of their emphasis on the knowledge problem and the impossibility of effective central planning, the Austrians (most notably Hayek) contended that legitimate law is nomos.  Thesis is something other than genuine law.  The common law, for the most part, is nomos.  Most (but not all) legislation is thesis.  The characterization of any piece of legislation will depend on whether it amounts to specific orders aimed at achieving a set purpose (e.g., the new federal health care law), in which case it is thesis, or is instead simply seeking to codify purpose-independent rules that settle parties’ expectations and enable them to order their affairs in light of the information to which they alone are privy (e.g., the Uniform Commercial Code), in which case it is nomos.  

Thom identifies insider trading as an example of a law that Austrians would regard as thesis:

If they were free to structure their relationship as best they saw fit, corporate investors and managers might well choose to allow managers to trade in the stock of their company on the basis of inside information.  As Henry Manne first observed, such trading could constitute an efficient compensation mechanism for managers and would also tend to make the corporation’s stock price, influenced by highly informative insider trades, more reflective of the corporation’s true business prospects (i.e., more efficient).  As corporations experimented with different insider trading policies, capital markets would tend to punish those that were value-destructive and reward those that were value-enhancing.  Federal securities law, however, prohibits investors and managers from crafting optimal insider trading policies.  Instead, the law forces a single policy on all corporations: managers generally may not trade on the basis of material, non-public information, even if investors would prefer that they be allowed to do so.  Such top-down, central planning of investor/manager relations is inconsistent with Austrian thought.  (And note that the insider trading ban conflicts with Austrian thought even if one construes the ban as a means of protecting the corporation’s property rights in information.  While the Austrians would certainly support policies that clarify who owns corporate information, they would oppose policies mandating that the ownership right be non-transferable from corporation to managers.)

I'm not an Austrian, of course. For example, I believe that an insider trading prohibition ought to be mandatory rather than a default.

As for why I am not an Austrian, I refer you to Bryan Caplan's brilliant essay Why I Am Not an Austrian Economist

The Insider Trading Case: I Guess Preet Bharara Never Bothered to Read Dirks v. SEC

John Carney explains that Manhattan US Attorney Preet Bharara has come up with a new rationale for justifying his huge insider trading prosecution:

... the new theory that is being marshaled against insider trading seems to be based on the idea that the pursuit of non-public information is resulting in an inefficient informational arms race. That’s the strongest case against the use of performance enhancing drugs in sports—that it creates an “arms race” atmosphere where players who wouldn’t otherwise use drugs feel pressured to begin using them to keep up with the enhanced players. In the end, if everyone ends up using performance enhancing drugs, no one winds up with an “unfair” advantage but lots of time and resources are wasted on the drugs.

In hedge fund investing, the analogy could be the use of these outside consultants that allegedly provide hedge funds with non-public information. Each fund manager has an incentive to seek the non-public information to gain a trading edge. But if everyone uses them, there’s no real advantage to their use. The time and resources spent acquiring the non-public information is simply wasted.

Bharara’s campaign against insider trading may be an attempt to end the informational arms race. That won’t make the playing field level—but it will make it so that naturally skilled traders are able to trade without inefficiently expending money to seek out non-public information. Which sort of makes you wonder if some of the top hedge fund managers—say, SAC Capital’s Steve Cohen—aren’t quietly cheering on the latest enforcement actions.

It's an interesting theory, which seems consistent with the facts. Look at who Bharara is targeting:

According to the Wall Street Journal, one of the Feds' targets in this probe is not a new one: so-called expert networks, which provide research "services" to hedge funds and mutual funds. Such services can include data and analysis, but very often consist merely of connecting a hedge fund analyst with an "expert" who might be a customer, client, or even employee of a company that the fund is an investor in. The networks reportedly being investigated are ones that most of us have never heard of: Primary Global Research and Broadband Research, both outfits that provide customers with intelligence about the technology industry.

To be sure, abuses of such networks might occur. BUT those networks also play a critical role in making markets more efficient. They help professional investors (the ones whose trading activities set prices) do a better job of valuing securities, which makes the market more efficient.

Because the defintion of insider trading is so vague, there is a risk that aggressive pursuit of these expert networks will chill legitimate activity. Justice Lewis Powell was well aware of this risk. In his seminal insider trading opinion Dirks v. SEC, he wrote that:

Imposing a duty to disclose or abstain 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).

From everything I've seen so far, this prosecution treads perilously close to the same sort of chilling effect about which Justice Powell was concerned in Dirks. Indeed, this case is worse in that it involves criminal charges, while Dirks was a mere civil censure penalty.

I wonder if USA Bharara's ever read Dirks and, if so, whether he understood it. My guess is "no."

Does Insider Trading Adversely Affect Investor Confidence?

Got an email from a reporter this am, which asked:

I am currently working on an article about the latest insider probe the WSJ has been reporting. I am especially interested in the concern that scandals like the alleged insider rings will further erode trust in Wall Street – not only investor’s but also companies - and what implications this might have for the overall US economy.

I responded by pointing to something I wrote in Insider Trading, in III Encyclopedia of Law & Economics 772 (Edward Elgar Publishing Ltd. 2000):

In the absence of a credible investor injury story, it is difficult to see why insider trading should undermine investor confidence in the integrity of the securities markets. As Bainbridge (1995, p.1241-42) observes, any anger investors feel over insider trading appears to arise mainly from envy of the insider’s greater access to information.

The loss of confidence argument is further undercut by the stock market’s performance since the insider trading scandals of the mid-1980s. The enormous publicity given those scandals put all investors on notice that insider trading is a common securities violation. If any investors believe that the SEC’s enforcement actions drove insider trading out of the markets, they are beyond mere legal help. At the same time, however, the years since the scandals have been one of the stock market’s most robust periods. One can but conclude that insider trading does not seriously threaten the confidence of investors in the securities markets.

Macey (1991, p. 44) contends that the experience of other countries confirms this conclusion. For example, Japan only recently began regulating insider trading and its rules are not enforced. The same appears to be true of India. Hong Kong has repealed its insider trading prohibition. Both have vigorous and highly liquid stock markets.

The Whys and Wherefores of Regulating Insider Trading

Larry Ribstein notes:

The WSJ has breathlessly reported:

Federal authorities, capping a three-year investigation, are preparing insider-trading charges that could ensnare consultants, investment bankers, hedge-fund and mutual-fund traders, and analysts across the nation, according to people familiar with the matter.

The criminal and civil probes, which authorities say could eclipse the impact on the financial industry of any previous such investigation, are examining whether multiple insider-trading rings reaped illegal profits totaling tens of millions of dollars, the people say. Some charges could be brought before year-end, they say.

The investigations, if they bear fruit, have the potential to expose a culture of pervasive insider trading in U.S. financial markets, including new ways nonpublic information is passed to traders through experts tied to specific industries or companies, federal authorities say.

Peter Lattman’s NYT story provides some perspective, noting that Justice and the SEC “have taken an increasingly aggressive — and public — stance in pursuing insider trading” and that the prosecutor in the latest case (as in the Galleon case), Manhattan U.S. attorney Preet Bharara, is among those taking the “hardest line.” 

Larry goes on to argue that:

All of this theater can’t hide the dubious public policy underlying these prosecutions.  Insider trading is, at worst, a breach of fiduciary duty which, like other such breaches, can be dealt with under state law.  There’s only the thinnest basis for getting the federal government involved — that insider trading might increase trading spreads and therefore might reduce trading by outsiders.  But sensible outsiders don’t do a lot of trading.

I don't agree. I think insider trading is theft of information and is punished for precisely the same reasons that we punish other forms of theft of property. I develop this argument at pages 78-82 of my monograph The Law and Economics of Insider Trading: A Comprehensive Primer.

To be sure, at first blush, the insider trading prohibition admittedly does not look very much like most property rights. Enforcement of the insider trading prohibition admittedly differs rather dramatically from enforcement of, say, trespassing laws. The existence of property rights in a variety of intangibles, including information, however, is well-established. Trademarks, copyrights, and patents are but a few of the better known examples of this phenomenon. There are striking doctrinal parallels, moreover, between insider trading and these other types of property rights in information. Using another’s trade secret, for example, is actionable only if taking the trade secret involved a breach of fiduciary duty, misrepresentation, or theft. This was an apt summary of the law of insider trading after the Supreme Court’s decisions in Chiarella and Dirks (although it is unclear whether liability for theft in the absence of a breach of fiduciary duty survives O’Hagan).

As for getting the federal government involved, I explain at page 78 that:

Where public policy argues for giving someone a property right, but the costs of enforcing such a right would be excessive, the state often uses its regulatory powers as a substitute for creating private property rights. Insider trading poses just such a situation.

On pages 83-84 I then elaborate on why I think the SEC has a comparative advantage over private parties in enforcing an insider trading prohibition.

Larry then argues that:

The vast majority of trading on non-public information does a lot of good by making stock prices more accurate and, occasionally, exposing fraud.

Again, I don't buy it. I address the issue in the section of my monograph entitled "Insider Trading and Efficient Pricing of Securities" (pages 65-68), which concludes that:

... if insider trading is to affect the price of securities, it is through the derivatively informed trading mechanism of market efficiency. ... The problem is that while derivatively informed trading can affect price, it functions slowly and sporadically. Given the inefficiency of derivatively informed trading, the market efficiency justification for insider trading loses much of its force.

I do agree with Larry that "criminalizing this conduct and unleashing aggressive publicity-seeking prosecutors to enforce the criminal laws is particularly dubious." The SEC has substantial civil penalties it can seek against inside traders, including treble money fines. When you add in the vagueness of what constitutes insider trading, criminal liability becomes very problematic. As I noted in connection with the Vizard case a few years ago:

... the SEC has vigorously resisted proposals to define insider trading in US law with anything like the precision of Australian law. As a result, as I pointed out in my article Insider Trading Regulation: The Path Dependent Choice between Property Rights and Securities Fraud, the definition of insider trading has been left to the courts to develop on a case-by-case basis, which in turn has left the law fairly vague on the margins, which gives significant advantages to prosecutors, especially in plea negotiations.

"Are Americans Bored with Counter-Terrorism?"

David Frum poses the titular question, asking:

Admittedly, this is probably an apocryphal story – and double admittedly I may be remembering it wrong. But the yarn goes that one day in 1954, Henry Luce was lunching with the editors of Time magazine and announced: “I’m bored with anticommunism.” Reading the intensifying round of complaints about the TSA’s practices, I’m left wondering: Is America now bored with antiterrorism?

Bored? No. Fed up with pointless, vastly expensive, perpetually getting worse, time wasting, privacy invading, soon to be anal probing security theater? Yes.

The law and economics of corporate governance

I'm reading The Law and Economics of Corporate Governance: Changing Perspectives, a collection of essays edited by Alessio Pacces.

Amazon's Product Description

In this timely book, the law and economics of corporate governance is approached from a range of angles. This study reveals that perspectives are changing: they differ between the economic and the legal standpoint; they vary across countries; they evolve over time. A group of leading scholars offer their views - some provide fresh empirical evidence on existing theories and others attempt to develop new theoretical insights based on empirical puzzles. They all analyse the economics of corporate governance with a view to how it should, or should not, be regulated. Economic analysis of law proves to be the common language for understanding corporate governance on both sides of the Atlantic.

The law and economics approach is applied to topical issues in the international debate, such as the harmonization of company laws; regulatory competition; determinants of separation of ownership and control; enforcement of investor protection; and the political economy of corporate governance.

There are a number of really good essays in the book. Along with two coauthors, my old friend Bill Carney has a great piece on the present state of Delaware corporation law. They argue that Delaware law is becoming less flexible and less predictable, thereby losing ground on two characteristics that long made Delaware corporation law the regime of choice. They further argue that Delaware remains dominant mainly because US law students are taught Delaware law in school and thus have limited knowledge of better alternatives. (Mea culpa.) Readers will want to also read a reply by Delaware Chancellor William Chandler to another version of the Carney paper.

My old friend and mentor Henry Manne also contributes an essay in which he demonstrates his continuing command of the debate. Not surprisingly, the essay focuses on the market for corporate control and insider trading. Henry picks up on Jon Macey's idea of "corporate governance as promise," and argues that corporate governance is best served by private ordering. It's provocative and challenging.

In sum, highly recommended.

The Tort Law Scholarship of Richard Epstein

The on-line Journal of Tort Law has a symposium dedicated to the tort law scholarship of famed libertarian law professor Richard Epstein, including a new essay by the man himself.

TSA Video

What'll TSA do when terrorists start putting bombs up their butts?

From today's hearing on TSA security procedures:

[Transportation Safety Administration chief John] Pistole defended the pat-downs because of the next generation of "non-metallic" explosives currently being used by terrorists.

So what will the groper-in-chief want when terrorists start sticking bombs up their asses or vaginas? A strip search coupled with a body cavity probe?