It's a somewhat obscure, but surprisingly interesting question of securities law, which Jay Brown analyzes in this post.
It's a somewhat obscure, but surprisingly interesting question of securities law, which Jay Brown analyzes in this post.
The SEC and US Department of Justice have often overreached in their efforts to police insider trading, especially when they think they can make a big bang by taking down a high profile person (see, e.g., the asinine case against Mark Cuban), but the purported case against Phil Mickelson is one of the most absurd yet.
The NY Times reports that:
In the summer of 2011, a series of winning stock trades raised immediate red flags for financial regulators.
The traders — a cross-section of investors including the championship golfer Phil Mickelson and the high-rolling gambler and golf course owner William T. Walters — collectively reaped several million dollars betting on the consumer products companyClorox and one other stock, according to people briefed on the matter who spoke anonymously because they were not authorized to discuss the investigation.
The trades, options contracts to buy Clorox stock, came just days before the billionaire investor Carl C. Icahn announced an unsolicited takeover bid for the company that drove up the stock price. And trading records indicated that the bets came not just from Mr. Mickelson but also from at least one other investor connected to Mr. Walters and the golfing world, one of the people briefed on the matter said. ...
As federal authorities examine whether Mr. Icahn leaked details of his Clorox bid to Mr. Walters, the people said, they are exploring a theory that Mr. Walters might have passed the information to Mr. Mickelson.
This case stinks. It seems to me that there are two possible theories of liability of here, neither of which stands up to close scrutiny. First, Rule 14e-3 prohibits persons who occupy a certain status such as the offering person, the subject company, or an officer, director, partner or employee or any other person acting on behalf of the offering person or the issuer from tipping off other persons about an impending tender offer. Further, it prohibits thise tippees from trading on the basis of such information. But Rule 14e-3 only applies if the offering person (i.e., the takeover bidder, which would be Icahn in this case) has taken substantial steps towards commencing a tender offer. According to the NY Times, however, "in the case of Clorox, Mr. Icahn never submitted a tender offer." In addition, even if Icahn had taken the requisite substantial steps towards commending a tender offer, Mickelson would have to know or have reason to know that the information was non-public and came indirectly from Icahn.
Second, case law under Rule 10b-5 says that tipping material nonpublic information can sometimes be illegal. None of the players in this case are insiders of Clorox, so the classic disclose or abstain rule would not apply. Instead, the SEC would have to proceed under a misappropriation theory. In order for that to work, the SEC at a minimum would have to prove that (1) Icahn tipped the information to Walters in breach of a fiduciary duty owed to the person or entity who owned the information, (2) that Icahn got a personal benefit for doing so, (3) that Walters passed the information to Mickelson, (4) Mickelson knew or should have known that the information came was material, nonpublic, and had been disclosed to him in violation of a fiduciary duty by the source. It should also be the case that the SEC will have to prove that Mickelson knew or should have known that Icahn got a personal benefit from making the tip, although that issue is currently pending before the Second Circuit.
The SEC's case would break down at several points. First, does Icahn owe a duty to anyone (say the investors in his hedge funds) that was breached by his disclosure? After all, isn't Icahn really disclosing his own intentions? Indeed, Forbes reports that "Icahn himself owned more than 90% of his Icahn Enterprises and had already moved to return all the outside money in his hedge fund." Tipping or trading on the basis of your own intentions is not illegal under Rule 10b-5.
Second, what personal benefit did Icahn get from making the disclosure?
Third, what did Mickelson know and how did he learn it? Can they link his trade to Icahn and, if so, did Mickelson known that Icahn was breaching a fiduciary duty (assuming he was) by making the disclosure.
I am not unsympathetic to the argument that putative shareholder activists like Carl Icahn need watching. As the WSJ reports:
The investigation signals that the FBI and the SEC are concerned about a potential dark side of shareholder activism. Activist investors push for broad changes at companies or try to move stock prices with their arguments. Mr. Icahn, a 78-year-old billionaire, has come to epitomize such activism in U.S. boardrooms.
Investigators are focusing on potentially abusive practices among such activists, including whether they are leaking information about their stakes before making public disclosures—the subject of a Wall Street Journal page-one article in March.
But while abuses by activists should be policed, I just don't see how the SEC or DOJ can possibly make this case stick.
I'm giving a talk at the University of Auckland Faculty of Law today on the titular subject of this post. I'll review of insider trading law, with emphasis on its application to recent cases involving hedge funds. Reviews Preet Bharara’s scorecard, the Galleon case, materiality and the “Mosaic Theory," and tipping chains.
Just as Americans found ways to keep drinking, Wall Street will always look for an edge.
The much-hyped modern insider-trading prosecutions and their results are reminiscent of nothing so much as Prohibition-era government attacks on bootleggers. There is about as much chance of stopping trading on undisclosed financial information as there ever was of stopping the consumption of booze. There is simply too much money sloshing around the world's stock exchanges waiting for an "edge." Information is more mercurial than mercury and will seep into some crevice in the system no matter how many channels are closed. ...
The imagination of wealth seekers in using valuable information in the stock market will always outpace the ability of regulators to cope. The payoffs are too big and too accessible and the number of willing players too great for the practice to be significantly inhibited by scores of convictions. But political reputations can still be made by convincing investors that these prosecutions are in their interest and will significantly alter the market's behavior.
The case for outlawing insider trading is even weaker than it was with alcohol. The latter did in many cases inflict real damage—to careers, family relationships, livers. Insider trading not only does no harm, it can have significant social and economic benefits including a more accurate pricing of stocks.
But that is not the story for today, and it has been told many times (and never seriously refuted). The story for today is that we are repeating the errors of Prohibition. We see federal prosecutors making names for themselves by convicting mostly low-level functionaries. We see the so-called corruption of otherwise good folks, including medical researchers and high-tech specialists, with valuable information. Yet with so much wealth at stake, this "corruption" surely goes far beyond what prosecutors have been able to demonstrate.
It is high time to stop this ridiculous posturing. We really don't need another government failure like Prohibition.
Go read the wohole thing?
Although Congress has mandated extremely draconian civil and criminal sanctions for insider trading, it has never seen fit to define what constitutes insider trading. Admittedly, insider trading is difficult to define with precision, but Congress also was concerned that even if a clear statutory definition could be devised, inside traders would find ways of evading it. See generally Stephen M. Bainbridge, Note, A Critique of the Insider Trading Sanctions Act of 1984, 71 VA. L. REV. 455, 472-73 (1985).
Accordingly, Congress deliberately left the definition of insider trading as vague and unconstrained as possible. In light of the draconian penalties associated with insider trading, however, this decision raises troubling vagueness concerns. As Jonathan Macey bluntly put it, “opposition to a clear, fixed definition for the crime of insider trading constitutes nothing less than a naked power grab by the SEC, a move obviously at odds with the most elemental notions of justice and fair play.” JONATHAN R. MACEY, INSIDER TRADING: ECONOMICS, POLITICS, AND POLICY 64 (1991). Or as Ed Kitch put it, somewhat less bluntly, “[t]he fact that the agency finds it more comfortable to avoid the discipline of defining the offense before bringing the charge is no reason for eschewing the increased fairness and deterrent efficacy that would flow from the exercise.” Edmund W. Kitch, A Federal Vision of the Federal Securities Laws, 70 VA. L. REV. 857, 861 (1984).
According to the WSJ, however, oral argument in an insider trading case pending before the Secomd Circuit suggests that that court may finally be willing to do something about this fundamental unfairness:
In an hourlong hearing in Manhattan, judges of the U.S. Court of Appeals for the Second Circuit signaled that federal prosecutors may have taken too broad a view of insider trading, saying Wall Street needs more of a "bright line" about what constitutes a crime. ...
Two members of the Second Circuit panel in Manhattan expressed concern that the prosecutors' approach is too vague.
"We sit in the financial capital of the world, and the amorphous theory you have gives precious little guidance to all these financial institutions and all these hedge funds out there about a bright-line theory as to what they can and cannot do," Judge Barrington D. Parker said.
The broader federal judiciary is closely watching the appeal, in part, because the law on insider trading is ambiguous.
Daniel Richman, a professor at Columbia Law School, said that because of the statute's ambiguity, most of the law concerning insider trading had been set by the courts, calling the tolerance for this "remarkable."
Remarkable strikes me as valid, but too weak. Try intolerable. Or indefensible. Or appalling.
It is time for courts to finally draw some very bright lines. As for where those lines should be drawn, I direct the interested reader to my article Regulating Insider Trading in the Post-Fiduciary Duty Era: Equal Access or Property Rights? (May 8, 2012). Available at SSRN: http://ssrn.com/abstract=2054814
In my new book, Insider Trading Law and Policy, I discuss liability in cases in which inside information is passed from one tipper to another in a so-called tipping chain:
Suppose, for example, that Tipper tells Tippee #1 who tells Tippee #2 who trades. Can Tippee #2 be held liable? If the preconditions of tipping liability are satisfied, there is nothing in Dirks to foreclose such liability. Donald Langevoort, for example, suggests that liability in tipping chain cases should require a three-part showing: “each person in the chain (1) was given the information expressly for the purpose of facilitating trading based on inside information, (2) knew that the information was material and nonpublic, and (3) knew or had reason to know that it came to him as a result of some breach of duty by an insider.” He goes on to note, however, that tipping chain cases—“albeit without any substantial judicial discussion of the underlying issue”—generally have imposed liability “simply on a showing that the person came into possession of information that he knew was material and nonpublic and which he knew or had reason to know was obtained via a breach of fiduciary duty by an insider.”
In Obus, for example, the Second Circuit opined that:
A tipper will be liable if he tips material non-public information, in breach of a fiduciary duty, to someone he knows will likely (1) trade on the information or (2) disseminate the information further for the first tippee’s own benefit. The first tippee must both know or have reason to know that the information was obtained and transmitted through a breach and intentionally or recklessly tip the information further for her own benefit. The final tippee must both know or have reason to know that the information was obtained through a breach and trade while in knowing possession of the information.
Obus, 693 F.3d at 288. The court further explained that the tippee could be held liable on the basis of “conscious avoidance,” citing SEC v. Musella, 678 F. Supp. 1060, 1063 (S.D.N.Y.1988), for the proposition that Dirks was “satisfied where the defendants, tippees at the end of a chain, ‘did not ask [about the source of information] because they did not want to know.’ ” Obus, 693 F.3d at 288–89.
As the WSJ reported on Monday, this issue is now on appeal before the Second Circuit:
The appeal is being pursued by Todd Newman and Anthony Chiasson, two portfolio managers whose 2012 insider-trading convictions were a significant victory for prosecutors. ...
The original trial judge told jurors that Messrs. Chiasson and Newman could be convicted of insider trading even if they hadn't known that the person who leaked the information had done so in return for a "personal benefit."
Lawyers for Messrs. Newman and Chiasson say prosecutors must show that their clients knew the tippers were somehow compensated for the tips and that the judge's instruction was erroneous. The inside tips on which the pair traded were conveyed through a network of analysts before reaching analysts who worked for Messrs. Chiasson and Newman, the lawyers said in court documents. Their clients didn't seek out or knowingly use inside information, they said.
Prosecutors have said they need only show that people who used the tips were aware the tipper disclosed the nonpublic information in breach of a fiduciary duty when they traded on it.
Even if the instruction was erroneous, the jury would have concluded the two men inferred the information was given in exchange for a reward, prosecutors said in court documents.
Given the phrasing of the Obus standard, the jury instruction may well hold up on appeal. On the other hand, the seminal Dirks v. SEC decision makes clear that the requisite breach of fiduciary duty is one in which the tipper gets a personal benefit in return for the tip, so shouldn't the personal benefit requirement be made explicit?
The problem here is that the Obus case erroneously phrased the Dirks standard. According to the Second Circuit:
The [Supreme] Court held that a tipper like the analyst in Dirks is liable if the tipper breached a fiduciary duty by tipping material non-public information, had the requisite scienter (to be discussed momentarily) when he gave the tip, and personally benefited from the tip. Id. at 660–62, 103 S.Ct. 3255. Personal benefit to the tipper is broadly defined: it includes not only “pecuniary gain,” such as a cut of the take or a gratuity from the tippee, but also a “reputational benefit” or the benefit one would obtain from simply “mak[ing] a gift of confidential information to a trading relative or friend.” Id. at 663–64, 103 S.Ct. 3255. When an unlawful tip occurs, the tippee is also liable if he knows or should know that the information was received from one who breached a fiduciary duty (such as an insider or a misappropriator) and the tippee trades or tips for personal benefit with the requisite scienter. See id. at 660, 103 S.Ct. 3255.
The highlighted text is the source of the problem. It suggested that the personal benefit and fiduciary duty requirements are separate. Under Dirks, however, they are one and the same:
In determining whether a tippee is under an obligation to disclose or abstain, it thus is necessary to determine whether the insider's “tip” constituted a breach of the insider's fiduciary duty. ... [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. And absent a breach by the insider, there is no derivative breach.
463 U.S. at 661-62. In other words, no personal benefit, no breach. Therefore, it seems to me, the jury should have been instructed that the prosecution has to prove that the tippees knew of recklessly avoided knowing that the tipper got a personal benefit.
if you believe the SEC, insider trading is a scourge that must be eliminated from our capital markets:
Because insider trading undermines investor confidence in the fairness and integrity of the securities markets, the SEC has treated the detection and prosecution of insider trading violations as one of its enforcement priorities.
Given all the effort the SEC spends on enforcing its absurd rules against insider trading and imposing the draconian penalties for violating those rules, one would expect that the SEC staff would be purer that Caesar's proverbial wife. But it turns out not to be the case:
People working for the U.S. Securities and Exchange Commission who owned stock in companies under investigation were more likely to sell shares than other investors in the months before the agency announced it was taking enforcement actions, according to a new academic paper.
SEC employees holding shares of five firms including JPMorgan Chase & Co. and General Electric Co. (GE) in 2010 and 2011 sold stock in 62 percent of the trades they initiated, compared with 50 percent among all the investors who traded those shares in that period, Emory University accounting professor Shivaram Rajgopal reports in the paper.
Rajgopal, who plans to present the work today at a University of Virginia accounting seminar, said in a telephone interview that while the analysis doesn’t prove misconduct it points out a suspicious pattern.
Of course, this isn't the only time the SEC has failed to police itself. To cite but one sore point, the SEC consistently fails to comply with the internal control rules it requires corporations to comply with.
Maybe in the future, the SEC will be a but less sanctimonious about its enforcement program.
But I doubt it.
Update: Broc Romanek claims to have debunked the study. Since I don't share his faith in the integrity of SEC (or any other government) employees, I'm not inclined to give the SEC a pass on this one.
Update 2: Steven Davidoff thinks the SEC staffer's gains are attrobutable to "dumb luck" rather than insider trading.
Got my copies today of Insider Trading Law and Policy. From the book description:
This compact text (260 pp) is for use in law school classes on insider trading, securities regulation, or business associations. It offers a clear and direct exposition of the law and policy concerns raised by this important and high-profile area of the law. The author provides sufficient detail for a complete understanding of the subject without getting bogged down in minutiae. Faculty interested in teaching a short course on insider trading or making insider trading a major part of a course in securities or corporate law will find the text highly teachable, while students taking such a course using other materials will find it a useful study aid.
Dr Paul Fryer reviews the Research Handbook on Insider Trading edited by yours truly in 2014 Journal of International Banking Law and Regulation 64-65:
This handbook, edited by Stephen M. Bainbridge, Professor of Law at the University of Californi, is designed to provide a broad overview of research focusing on insider trading, predominantly in the United States but also offer global perspectives from Asia, Australasia, and Europe. It also seeks to provide an additional dimension by critically examining some of more challenging and under-explored aspects of financial crime. ...
This research handbook is, in parts, highly innovative with chapters that focus on areas not generally associated with insider trading activities, such as gender and the impact of social media activities. However, the vast majority of chapters focus on "nuts and bolts" issues that academics and practitioners in this field with be familiar with. Stephen Bainbridge and his contributors have produced a valuable reference source for scholars and practitioners of corporate law who wish to gain a greater understanding of insider trading.
Page 2, footnote 3 of Bhattacharya , Utpal, Insider Trading Controversies: A Literature Review (October 15, 2013). Available at SSRN: http://ssrn.com/abstract=2340518:
No brag, just fact.
Lyle Roberts defended Mark Cuban against the absurd SEC insider trading charges to which Cuban was subjected. In today's WSJ, Roberts critiques the case against his client:
When Mark Cuban stood outside the federal courthouse in Dallas last month—after a jury found him not liable for insider trading—he noted that the Securities and Exchange Commission lacks "bright-line rules" and resorts to "regulation through litigation." Mr. Cuban, who owns the Dallas Mavericks basketball team, raises a very good point. In pursuing insider-trading claims, the SEC often appears to be making up the rules as it goes along. This is not healthy behavior for government law enforcement. ...
In its Nov. 17, 2008, press release announcing its lawsuit against Mr. Cuban—I represented him in the case—the SEC claimed that it was "fundamentally unfair for someone to use access to nonpublic information to improperly gain an edge on the market." Statements like this are misleading. Contrary to a popular misconception about insider trading, there is nothing wrong with a person trading on the basis of nonpublic information about a corporation.
That is, of course, absolutely correct. In Chiarella v. United States, the Supreme Court made clear that when a Rule 10b-5 action is based upon nondisclosure, as is always true in insider trading cases, there can be no fraud absent a duty to speak, and no such duty arises from the mere possession of nonpublic information. The trouble, of course, is that the SEC has never accepted Chiarella and has done everything in its power to evade and eviscerate Chiarella's holding.
An entire profession—the stock market analyst—is predicated on the idea that investors can and should seek an informational advantage to better manage their investments. Trading based on an informational advantage is only illegal when it results in a fraud, and that only happens in certain narrow circumstances.
Also entirely correct. As I noted in an earlier post, however, the SEC's enforcement program has been structured--one can but assume intentionally so--to chill legitimate market research.
[The SEC in 2000 adopted] a regulatory rule (Rule 10b5-2) designed to address how the misappropriation theory could be extended to exchanges of information between friends or family members. Under the rule, the required duty of trust and confidence is formed any time a friend or family member formally agrees to keep the information confidential.
Soon thereafter, however, the SEC began citing Rule 10b5-2 in courts across the country as applying whenever any material, nonpublic information is exchanged and the recipient, regardless of whether he is a friend or family member, formally agrees to keep the information confidential. Recently, the SEC abandoned even that broad standard and essentially has argued that a wink and a nod (or even silence) to confidentiality when material, nonpublic information is shared is sufficient to hold anyone who trades on that information liable for insider trading.
Sadly, also true. Now for the conclusion:
In the wake of this case, the SEC needs to re-evaluate its insider trading program. It—or Congress—should clarify that under the misappropriation theory of insider trading, the required relationship of trust and confidence can be created by agreement only if someone who receives material, nonpublic information about a company agrees to keep that information confidential and not trade on it. These are standard terms in corporate nondisclosure agreements.
No. No. A thousand times, no! As I wrote in an earlier post:
Under Dirks, "the individual must have expressly or impliedly entered into a fiduciary relationship with the issuer." SEC v. Ingram, 694 F.Supp. 1437, 1440 (C.D.Cal.1988).
Unfortunately for Cuban, there are some cases that suggest a mere contractual obligation of confidentiality suffices. See, e.g., SEC v. Talbot, 430 F. Supp.2d 1029 (C.D. Cal. 2006) (holding that absent an express agreement to maintain the confidentiality of information, the mere reposing of confidential information in another does not give rise to the necessary fiduciary duty). I believe these cases were wrongly decided.
Chiarella and Dirks clearly require something more than a mere contract. They require a fiduciary relationship. In turn, a fiduciary relationship requires mre than just an arms-length contract:
A fiduciary relationship involves discretionary authority and dependency: One person depends on another?the fiduciary?to serve his interests. In relying on a fiduciary to act for his benefit, the beneficiary of the relation may entrust the fiduciary with custody over property of one sort or another. Because the fiduciary obtains access to this property to serve the ends of the fiduciary relationship, he becomes duty-bound not to appropriate the property for his own use.
The most relevant precedent here would be Walton v. Morgan Stanley & Co.,623 F.2d 796 (2d Cir.1980). Morgan Stanley represented a company considering acquiring Olinkraft Corporation in a friendly merger. During exploratory negotiations Olinkraft gave Morgan confidential information. Morgan's client ultimately decided not to pursue the merger, but Morgan allegedly later passed the acquired information to another client planning a tender offer for Olinkraft. In addition, Morgan's arbitrage department made purchases of Olinkraft stock for its own account. The Second Circuit held that Morgan was not a fiduciary of Olinkraft: "Put bluntly, although, according to the complaint, Olinkraft's management placed its confidence in Morgan Stanley not to disclose the information, Morgan owed no duty to observe that confidence." AlthoughWalton was decided under state law, it has been cited approvingly in a number of federal insider trading opinions. Hence, I believe the cases finding liability based on a mere contractual duty of confidentiality are wrongly decided. ...
The SEC will claim that the Mamma.com CEO was the source of the information and that Cuban owed him a duty of confidentiality arising not out of a traditional fiduciary relationship but rather out of a similar relationship of trust and confidence. The SEC will then rely on Rule 10b5-2, which provides "a nonexclusive list of three situations in which a person has a duty of trust or confidence for purposes of the 'misappropriation' theory...." Crucially, the Rule purports that such a duty exists whenever someone agrees to maintain information in confidence. Rule 10b5-2's imposition of liability whenever someone agrees to maintain information in confidence is inconsistent with the emphasis in Chiarella and its progeny on the need for a duty of disclosure that arises out of a relationship of trust and confidence. Whether the SEC has authority to create a rule imposing misappropriation liability on the basis of an arms-length contractual duty of confidentiality--as opposed to a fiduciary duty-based duty of confidentiality--has not been tested. For the reasons stated above, however, I think the SEC lacked authority to adopt the rule.
Contra the otherwise estimable Mr. Roberts, I thus believe that to the extent Rule 10b5-2 imposes liability on the basis of a mere agreement rather than a fiduciary relationship the rule is invalid, improper, an a gross abuse of the SEC's discretion.
I got an email from one of Mark Cuban's lawyers in regard to this post about the upshot of the Cuban case. In pertinent part, it reads:
In the Cuban case, the district court invalidated Rule 10b5-2 in its motion to dismiss decision.“Because Rule 10b5-2(b)(1) attempts to predicate misappropriation theory liability on a mere confidentiality agreement lacking a non-use component, the SEC cannot rely on it to establish Cuban’s liability under the misappropriation theory. To permit liability based on Rule 10b5-2(b)(1) would exceed the SEC’s Sec. 10(b) authority to proscribe conduct that is deceptive.” SEC v. Cuban, 634 F.Supp.2d 713, 730-31 (N.D. Tex. 2009).On appeal, the Fifth Circuit did not disturb that holding.“Given the paucity of jurisprudence on the question of what constitutes a relationship of ‘trust and confidence’ and the inherently fact-bound nature of determining whether such a duty exists, we decline to first determine or place our thumb on the scale in the district court's determination of its presence or to now draw the contours of any liability it might bring, including the force of Rule 10b5-2(b)(1). FN40. FN40: Nor must we reach the validity of Rule 10b5-2(b)(1).” SEC v. Cuban, 620 F.3d 551, 558 (5th Cir. 2010).Accordingly, at trial, the SEC was required to prove (contra Rule 10b5-2) that Mr. Cuban entered into an agreement to BOTH keep the information confidential AND not trade on or otherwise use the information for his own benefit. The jury found that he did NOT enter into any such agreement (in addition to finding that the information Mr. Cuban received was not material, nonpublic information).To that extent, I think it is more accurate to say that Mr. Cuban did, at least in part, “beat his insider trading charges by having a court rule that SEC Rule 10b5-2 was invalid.” At the moment, of course, that holding does not extend beyond the persuasive value of the district court’s decision, but it’s a start!
The guilty plea hearing last week in the Justice Department’s prosecution of SAC Capital Advisors raised an interesting question about the law of insider trading: Just who are the victims of a violation? A provision of the federal securities laws gives those who traded at the same time as the insider a right to sue for a violation, but the Justice Department said they are not victims of the crime. ...
Instead, the focus in insider trading prosecutions is on protection of the markets, and the broader economy, as the true victim of the violation. In sentencing Raj Rajaratnam to 11 years in prison after his conviction, Federal District Court Judge Richard J. Holwell said that “insider trading is an assault on the free markets” and the “crimes reflect a virus in our business culture that needs to be eradicated.”
Yet the federal securities law sends a different message by authorizing those who traded at the time of the insider transactions to pursue a private lawsuit. The case filed by the Elan and Wyeth investors against SAC is under a little used provision,Section 20A of the Securities Exchange Act of 1934, that gives “contemporaneous traders” a right to sue those trading on inside information. ...
That creates an odd situation because investors on the opposite side of the transactions are provided a right to enforce the law but are not considered victims of the crime for purposes of whether to accept a plea agreement involving the same trades.
Insider trading is more about the unfairness of someone realizing benefits from unauthorized trading on confidential information than about identifying victims of the violation.
Sorry, but much of that analysis is wrong. To be sure, Henning is correct that individual investors are not the "victims" of insider trading. As I explain in Insider Trading: An Overview. Available at SSRN: http://ssrn.com/abstract=132529:
Insider trading is said to harm the investor in two principal ways. Some contend that the investor’s trades are made at the “wrong price.” A more sophisticated theory posits that the investor is induced to make a bad purchase or sale. Neither argument proves convincing on close examination.
An investor who trades in a security contemporaneously with insiders having access to material nonpublic information likely will allege injury in that he sold at the wrong price; i.e., a price that does not reflect the undisclosed information. If a firm’s stock currently sells at $10 per share, but after disclosure of the new information will sell at $15, a shareholder who sells at the current price thus will claim a $5 loss. The investor’s claim, however, is fundamentally flawed. It is purely fortuitous that an insider was on the other side of the transaction. The gain corresponding to shareholder’s “loss” is reaped not just by inside traders, but by all contemporaneous purchasers whether they had access to the undisclosed information or not. Bainbridge (1986, p.59).
To be sure, the investor might not have sold if he had had the same information as the insider, but even so the rules governing insider trading are not the source of his problem. The information asymmetry between insiders and public investors arises out of the federal securities laws’ mandatory disclosure rules, which allow firms to keep some information confidential even if it is material to investor decisionmaking. Unless immediate disclosure of material information is to be required, a step the law has been unwilling to take, there will always be winners and losers in this situation. Irrespective of whether insiders are permitted to inside trade or not, the investor will not have the same access to information as the insider. It makes little sense to claim that the shareholder is injured when his shares are bought by an insider, but not when they are bought by an outsider without access to information. To the extent the selling shareholder is injured, his injury thus is correctly attributed to the rules allowing corporate nondisclosure of material information, not to insider trading.
A more sophisticated argument is that the price effects of insider trading induce shareholders to make poorly advised transactions. In light of the evidence and theory recounted above in Section 6, however, it is doubtful whether insider trading produces the sort of price effects necessary to induce shareholders to trade. While derivatively informed trading can affect price, it functions slowly and sporadically. Gilson and Kraakman (1984, p.631). Given the inefficiency of derivatively informed trading, price or volume changes resulting from insider trading will only rarely be of sufficient magnitude to induce investors to trade.
Assuming for the sake of argument that insider trading produces noticeable price effects, however, and further assuming that some investors are misled by  those effects, the inducement argument is further flawed because many transactions would have taken place regardless of the price changes resulting from insider trading. Investors who would have traded irrespective of the presence of insiders in the market benefit from insider trading because they transacted at a price closer to the “correct” price; i.e., the price that would prevail if the information were disclosed. Dooley (1980, p.35-36); Manne (1966b, p.114). In any case, it is hard to tell how the inducement argument plays out when investors are examined as a class. For any given number who decide to sell because of a price rise, for example, another group of investors may decide to defer a planned sale in anticipation of further increases.
But the idea that a prohibition of insider trading is necessary to protect the markets is simply not true, as I explain in that article:
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.
Likewise, insider trading is simply not unfair. Granted, there seems to be a widely shared view that there is something inherently sleazy about insider trading. As a California state court put it, insider trading is “a manifestation of undue greed among the already well-to-do, worthy of legislative intervention if for no other reason than to send a message of censure on behalf of the American people.”
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, 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 insider trading injures investors, which seems unlikely for the reasons discussed in the next section. Accordingly, fairness concerns need not detain us further; instead, we can turn directly to the economic arguments against insider trading.
Instead, insider trading is a problem only to the extent that it involves theft of information:
There are essentially two ways of creating property rights in information: allow the owner to enter into transactions without disclosing the information or prohibit others from using the information. In effect, the federal insider trading prohibition vests a prop-erty right of the latter type in the party to whom the insider trader owes a fiduciary duty to refrain from self-dealing in confidential information. To be sure, at first blush, the in-sider 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 in-tangibles, 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. As Dooley (1995, p.776) observes, this is an apt summary of the law of insider trad-ing after the Supreme Court’s decisions in Chiarella and Dirks.
In context, moreover, even the insider trading prohibition’s enforcement mechanisms are not inconsistent with a property rights analysis. 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. Private enforcement of the insider trading laws is rare and usually parasitic on public enforcement proceedings. Dooley (1980, p.15-17) . Indeed, the very nature of insider trading arguably makes public regulation essential pre-cisely because private enforcement is almost impossible. Bainbridge (1993, p.29) . The insider trading prohibition’s regulatory nature thus need not preclude a property rights-based analysis.
The rationale for prohibiting insider trading is precisely the same as that for prohibit-ing patent infringement or theft of trade secrets: protecting the economic incentive to produce socially valuable information. (An alternative approach is to ask whether the par-ties, if they had bargained over the issue, would have assigned the property right to the corporation or the inside trader. For a hypothetical bargain-based argument that the prop-erty right would be assigned to the corporation in the lawyer—corporate client context, see Bainbridge (1993, p. 27-34) .)
As the theory goes, the readily appropriable nature of information makes it difficult for the developer of a new idea to recoup the sunk costs incurred to develop it. If an in-ventor develops a better mousetrap, for example, he cannot profit on that invention with-out selling mousetraps and thereby making the new design available to potential competitors. Assuming both the inventor and his competitors incur roughly equivalent marginal costs to produce and market the trap, the competitors will be able to set a mar-ket price at which the inventor likely will be unable to earn a return on his sunk costs. Ex post, the rational inventor should ignore his sunk costs and go on producing the improved mousetrap. Ex ante, however, the inventor will anticipate that he will be unable to gener-ate positive returns on his up-front costs and therefore will be deterred from  devel-oping socially valuable information. Accordingly, society provides incentives for inventive activity by using the patent system to give inventors a property right in new ideas. By preventing competitors from appropriating the idea, the patent allows the inven-tor to charge monopolistic prices for the improved mousetrap, thereby recouping his sunk costs. Trademark, copyright, and trade secret law all are justified on similar grounds.
This argument does not provide as compelling a justification for the insider trading prohibition as it does for the patent system. A property right in information should be created when necessary to prevent conduct by which someone other than the developer of socially valuable information appropriates its value before the developer can recoup his sunk costs. Insider trading, however, often does not affect an idea’s value to the corpora-tion and probably never entirely eliminates its value. Legalizing insider trading thus would have a much smaller impact on the corporation’s incentive to develop new infor-mation than would, say, legalizing patent infringement.
The property rights approach nevertheless has considerable justificatory power. Con-sider the prototypical insider trading transaction, in which an insider trades in his em-ployer’s stock on the basis of information learned solely because of his position with the firm. There is no avoiding the necessity of assigning the property right to either the cor-poration or the inside trader. A rule allowing insider trading assigns the property right to the insider, while a rule prohibiting insider trading assigns it to the corporation.
From the corporation’s perspective, we have seen that legalizing insider trading would have a relatively small effect on the firm’s incentives to develop new information. In some cases, however, insider trading will harm the corporation’s interests and thus adversely affect its incentives in this regard. This argues for assigning the property right to the corporation, rather than the insider.
Those who rely on a property rights-based justification for regulating insider trading also observe that creation of a property right with respect to a particular asset typically is not dependent upon there being a measurable loss of value resulting from the asset’s use by someone else. Indeed, creation of a property right is appropriate even if any loss in value is entirely subjective, both because subjective valuations are difficult to measure for purposes of awarding damages and because the possible loss of subjective values pre-sumably would affect the corporation’s incentives to cause its agents to develop new in-formation. As with other property rights, the law therefore should simply assume (although the assumption will sometimes be wrong) that assigning the property right to agent-produced information to the firm maximizes the social incentives for the produc-tion of valuable new information.
 Because the relative rarity of cases in which harm occurs to the corporation weakens the argument for assigning it the property right, however, the critical issue may be whether one can justify assigning the property right to the insider. On close examina-tion, the argument for assigning the property right to the insider is considerably weaker than the argument for assigning it to the corporation. As we have seen, some have argued that legalized insider trading would be an appropriate compensation scheme. In other words, society might allow insiders to inside trade in order to give them greater incen-tives to develop new information. As we have also seen, however, this argument appears to founder on grounds that insider trading is an inefficient compensation scheme. Even assuming that the change in stock price that results once the information is released accu-rately measures the value of the innovation, the insider’s trading profits are not correlated to the value of the information. This is so because his trading profits are limited not by the value of the information, but by the amount of shares the insider can purchase, which in turn depends mainly upon his ex ante wealth or access to credit.
A second objection to the compensation argument is the difficulty of restricting trad-ing to those who produced the information. The costs of producing information normally are much greater than the costs of distributing it. Thus, many firm employees may trade on the information without having contributed to its production.
The third objection to insider trading as compensation is based on its contingent na-ture. If insider trading were legalized, the corporation would treat the right to inside trade as part of the manager’s compensation package. Because the manager’s trading returns cannot be measured ex ante, however, the corporation cannot ensure that the manager’s compensation is commensurate with the value of her services.
The economic theory of property rights in information thus cannot justify assigning the property right to insiders rather than to the corporation. Because there is no avoiding the necessity of assigning the property right to the information in question to one of the relevant parties, the argument for assigning it to the corporation therefore should prevail.
The argument in favor of assigning the property right to the corporation becomes even stronger when we move outside the prototypical situation to cases covered by the misappropriation theory. It is hard to imagine a plausible justification for assigning the property right to those who steal information.