And so my debate with former SEC Chairman Harvey Pitt (who you will recall got run out of office for his incompetent fumbling of the Enron era scandals) has come to an end. The closing arguments are here.
Throughout the debate, Pitt has relied on standard shopworn and fallacious defenses for the insider trading prohibition. In his closing argument, for example, he trots out two old chestnuts:
Mr Bainbridge's core argument, which focuses almost exclusively on the role played by market analysts, ignores the value of fairness and the importance of investor confidence in capital markets.
Poppycock. As I explain in my chapter on insider trading in the “Encyclopedia of Law and Economics":
[Because insider trading does not injure investors, as I demonstrated in my closing statement at The Economist], 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 Hong Kong has repealed its insider trading prohibition.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.
In sum, neither investor protection nor maintenance of confidence have much traction as theoretical justifications for any prohibition of insider trading. Nor do they have much explanatory power with respect to the prohibition currently on the books. An investor's rights vary widely depending on the nature of the insider trading transaction; the identity of the trader; and the source of the information. Yet, if the goal is investor protection, why should these considerations be relevant?
Consider, for example, United States v. Carpenter, 791 F.2d 1024, 1026–27 (2d Cir.1986), aff'd, 484 U.S. 19 (1987). R. Foster Winans wrote the Wall Street Journal's "Heard on the Street" column, a daily report on various stocks that is said to affect the price of the stocks discussed. Journal policy expressly treated the column's contents prior to publication as confidential information belonging to the newspaper. Despite that rule, Winans agreed to provide several co-conspirators with prepublication information as to the timing and contents of future columns. His fellow conspirators then traded in those stocks based on the expected impact of the column on the stocks' prices, sharing the profits. In affirming their convictions, the Second Circuit anticipated O'Hagan by holding that Winans's breach of his fiduciary duty to the Wall Street Journal satisfied the standards laid down in Chiarella and Dirks. From either an investor protection or confidence in the market perspective, however, this outcome seems bizarre at best. For example, any duties Winans owed in this situation ran to an entity that had neither issued the securities in question nor even participated in stock market transactions. What Winans's breach of his duties to the Wall Street Journal has to do with the federal securities laws, if anything, is not self-evident.
The incongruity of the misappropriation theory becomes even more apparent when one considers that its logic suggests that the Wall Street Journal could lawfully trade on the same information used by Winans. If we are really concerned with protecting investors and maintaining their confidence in the market's integrity, the inside trader's identity ought to be irrelevant. From the investors' point of view, insider trading is a matter of concern only because they have traded with someone who used their superior access to information to profit at the investor's expense. As such, it would not appear to matter whether it is Winans or the Journal on the opposite side of the transaction. Both have greater access to the relevant information than do investors.
The logic of the misappropriation theory also suggests that Winans would not have been liable if the Wall Street Journal had authorized his trades. In that instance, the Journal would not have been deceived, as O'Hagan requires. Winans' trades would not have constituted an improper conversion of nonpublic information, moreover, so that the essential breach of fiduciary duty would not be present. Again, however, from an investor's perspective, it would not seem to matter whether Winans's trades were authorized or not.
Finally, conduct that should be lawful under the misappropriation theory is clearly proscribed by Rule 14e–3. A takeover bidder may not authorize others to trade on information about a pending tender offer, for example, even though such trading might aid the bidder by putting stock in friendly hands. If the acquisition is to take place by means other than a tender offer, however, neither Rule 14e–3 nor the misappropriation theory should apply. From an investor's perspective, however, the form of the acquisition seems just as irrelevant as the identity of the insider trader.
All of these anomalies, oddities, and incongruities have crept into the federal insider trading prohibition as a direct result of Chiarella's imposition of a fiduciary duty requirement. None of them, however, are easily explicable from either an investor protection or a confidence in the market rationale.
Turning to Pitt's fairness argument, I concede that there is a widely shared view that there is something inherently sleazy about insider trading. Given the draconian penalties associated with insider trading, however, vague and poorly articulated notions of fairness surely provide an insufficient justification for the prohibition. Can we identify a standard of reference by which to demonstrate that insider trading ought to be prohibited on fairness grounds? In my judgment, we cannot.
Fairness can be defined in various ways. Most of these definitions, however, collapse into the various efficiency-based rationales for prohibiting insider trading. We might define fairness as fidelity, for example, by which I mean the notion that an agent should not cheat her principal. But this argument only has traction if insider trading is in fact a form of cheating, which in turn depends on how we assign the property right to confidential corporate information. Alternatively, we might define fairness as equality of access to information, as many courts and scholars have done, but this definition must be rejected in light of Chiarella's rejection of the Texas Gulf Sulphur equal access standard. Finally, we might define fairness as a prohibition of injuring another. But such a definition justifies an insider trading prohibition only if investors are injured by insider trading, which seems unlikely (as I explain in that final Economist post).
By all accounts Pitt's a pretty smart guy, despite his ineptitude as SEC Chairman. So why does he trot out arguments, like these, that have been debunked for decades?
Pitt is an SEC guy. In addition to his lamentable stint as Chairman, he had been general counsel at the Commission, a founder and first President of the SEC Historical Society, and remains a Commission cheerleader. In is closing argument, for example, he still lauds the Commission:
The SEC was created in the aftermath of the stockmarket crash of 1929 to restore investor confidence in America's capital markets, and it should be credited for advancing these same goals today.
Credited? For what? For botching the handling of the Enron-era scandals? For botching the handling of the Bernie Madoff investigation? For repeatedly having failed GAO evaluations of the Commission's internal controls? For impeding capital formation? For supervising the decline of US capital markets as they lost competitiveness with global markets?
It's important to see Pitt's support for aggressive insider trading prosecutions as being part and parcel of the way the Commission has used (make that, abused) insider trading for decades.
When viewed from a public choice perspective, the federal insider trading prohibition may be understood as the culmination of two SEC agenda items. First, as do all government agencies, the SEC desires to enlarge its jurisdiction and enhance its prestige. Administrators can maximize their salaries, power, and reputation by maximizing the size of their agency's budget. A vigorous enforcement program directed at a highly visible and unpopular law violation is surely an effective means of attracting political support for larger budgets. Given the substantial media attention directed towards insider trading prosecutions, and the public taste for prohibiting insider trading, it provides a very attractive subject for such a program.
Second, during the prohibition's formative years, there was a major effort to federalize corporation law. In order to maintain its budgetary priority over competing agencies, the SEC wanted to play a major role in federalizing matters previously within the state domain. Insider trading was an ideal target for federalization. Rapid expansion of the federal insider trading prohibition purportedly demonstrated the superiority of federal securities law over state corporate law. Because the states had shown little interest in insider trading for years, federal regulation demonstrated the modernity, flexibility, and innovativeness of the securities laws. The SEC's prominent role in attacking insider trading thus placed it in the vanguard of the movement to federalize corporate law and ensured that the SEC would have a leading role in any system of federal corporations law.
The validity of this hypothesis is suggested by its ability to explain the SEC's devotion of significant enforcement resources to insider trading during the 1980s. During that decade, the SEC embarked upon a limited program of deregulating the securities markets. Among other things, the SEC adopted a safe harbor for projections and other soft data, the shelf registration rule, the integrated disclosure system, and expanded the exemptions from registration under the Securities Act. At about the same time, however, the SEC adopted a vigorous enforcement campaign against insider trading. Not only did the number of cases increase substantially, but the SEC adopted a "big bang" approach under which it focused on high visibility cases that would produce substantial publicity. In part this may have been due to an increase in the frequency of insider trading, but the public choice story nicely explains the SEC's interest in insider trading as motivated by a desire to preserve its budget during an era of deregulation and spending restraint.
The public choice story also explains the SEC's continuing attachment to the equal access approach to insider trading. The equal access policy generates an expansive prohibition, which federalizes a broad range of conduct otherwise left to state corporate law, while also warranting a highly active enforcement program. As such, the SEC's use of Rule 14e–3 and the misappropriation theory to evade Chiarella and Dirks makes perfect sense. By these devices, the SEC restored much of the prohibition's pre-Chiarella breadth and thereby ensured that its budget-justifying enforcement program would continue unimpeded.
As a loyal SEC foot soldier, it's thus hardly surprising that Pitt continues to tell the SEC's bogus stories about insider trading. They are essential to the political success of the SEC. Indeed, it is hardly surprising the present crackdown on insider trading came along when it did. It's not that insider trading suddenly surged. Instead, it's because the SEC had so publicly screwed up in the Madoff case and in the financial crisis. Going after insider trading was a way of taking some of the heat off the agency by racking up some wins.