Willie Sutton famously opined that he robbed banks because that was where the money was. His quip came to mind when I read Justin Fox's interesting critique of the SAC Capital indictment:
Five years after a financial crisis that, as best anybody can tell, had almost nothing to do with insider trading by hedge funds, the two biggest post-crisis criminal crackdowns on the financial sector in the U.S. have centered on ... insider trading by hedge funds. ...
... Bharara and his predecessors (Rudy Giuliani held the same job in the late 1980s) have taken on insider trading cases because they can win them. Thanks to a half century of SEC opinions and court rulings, insider trading is much easier to prosecute than other dodgy financial behavior. ...
The ban on insider trading dates to an era when the stock market was the biggest financial show in town, and small investors still controlled a big percentage of it. Now institutions dominate stock trading, and publicly traded stocks are a relatively small part of a burgeoning financial universe of private equity, debt, commodities, derivatives, and more. Yet most government investigative and prosecutorial energy seems to remain focused on insider trading in stocks — because that's where cases can be won.
Easy convictions and plea deals are to prosecutors what money is to bank robbers, so it makes sense that they'd focus on insider trading as opposed to more important stuff.
Thanks also to Fox for his shout out:
I will not claim to have read all or even most of the contributions to these volumes (law professors write long), but just dipping into them is an educational if bewildering experience. (The Langevoort article cited above is from the Columbia Business Law Review; my brief history of insider trading law is partly cribbed from Bainbridge's introduction to the Handbook.) The main lesson I learned is that the case against insider trading is much less about specific harms than a belief that it's bad for financial markets in general.
Go read the whole thing. It's a great analysis.
Apparently concluding that they don't have an insider trading case against hedge fund manager Steven Cohen, US Attorney Preet Bharara and his busybody minions have decided to indict SAC Capital and related firms for insider trading (are there no mafia bosses orterorrists they could be more usefully hunting down?).
Preet Bharara, the United States Attorney for the Southern District of New York, and George Venizelos, the Assistant Director-in-Charge of the New York Office of the Federal Bureau of Investigation (“FBI”), announced today the unsealing of insider trading charges against four companies – S.A.C. CAPITAL ADVISORS, L.P. (“SAC Capital LP”), S.A.C. CAPITAL ADVISORS, LLC (“SAC Capital LLC”), CR INTRINSIC INVESTORS, LLC (“CR Intrinsic”), and SIGMA CAPITAL MANAGEMENT, LLC (“Sigma Capital”), collectively (the “SAC Companies”). The SAC Companies are responsible for the management of a group of affiliated hedge funds, collectively (the “SAC Hedge Fund” or “SAC”). Charges were also unsealed today against RICHARD LEE, a portfolio manager employed by SAC Capital LP, who focused on “special situations” like mergers and acquisitions, private equity buy-outs, and corporate restructurings in publicly-traded companies across various industry sectors. LEE pled guilty on July 23, 2013, before U.S. District Judge Paul G. Gardephe, to conspiracy and securities fraud charges in connection with his work at SAC Capital LP.
The SAC Companies are charged with criminal responsibility for insider trading offenses. These alleged offenses were committed by numerous employees, occurred over the span of more than a decade, and involved the securities of more than 20 publicly-traded companies across multiple sectors of the economy. It is charged that the acts of these employees were made possible by institutional practices that encouraged the widespread solicitation and use of material, non-public information (“Inside Information”). This activity allegedly resulted in hundreds of millions of dollars in illegal profits and avoided losses at the expense of members of the investing public. The SAC Companies are expected to be arraigned on the charges on tomorrow at 10:00 a.m. before U.S. District Judge Laura Taylor Swain.
Manhattan U.S. Attorney Preet Bharara said: “A company reaps what it sows, and as alleged, S.A.C. seeded itself with corrupt traders, empowered to engage in criminal acts by a culture that looked the other way despite red flags all around. S.A.C. deliberately encouraged the no-holds-barred pursuit of an ‘edge’ that literally carried it over the edge into corporate criminality. Companies, like individuals, need to be held to account and need to be deterred from becoming dens of corruption. To all those who run companies and value their enterprises, but pay attention only to the money their employees make and not how they make it, today’s indictment hopefully gets your attention.”
What's the legal theory for holding SAC liable? As Donald Langevoort explains in his excellent treatise Insider Trading: Regulation, Enforcement, and Prevention:
Persons who possess or receive material nonpublic information in the course of their employment might well decide to trade on the basis of that information for their employer's proprietary trading account. That could happen when the employer is the issuer itself, as in the case where management engages in a stock repurchase program at the same time that they are aware of undisclosed positive information about the company's prospects. Or, more frequently, it could be a case where an employee of an investment firm, a broker-dealer, for example, receives a tip from some company insider and buys or sells stock in the insider's company for his firm's account on the basis of the tip.
In either case, liability under the federal securities laws would be fairly straightforward. Legally, the firm itself is the purchaser or seller of the securities; hence, this would be an issue of primary (not secondary) liability. When the issuer itself is the purchaser, it is deemed to "know" all information known by its officers, directors and senior management—indeed, probably all agents and employees—unless such persons are acting outside the scope of their employment or contrary to its interests. As a result, the basic test for liability under Rule 10b-5 is readily satisfied in the typical case: the company is trading while in possession of material nonpublic information. ...
The same result would follow in the case where the employer is trading in securities other than its own, assuming that the employee trading on its behalf is deemed a temporary insider or a tippee under the Dirks rationale or misappropriated the information in question. Again, the knowledge of the employee is attributed to the employer, since the information came to him or was used in the course of employment for the employer's benefit. The fiduciary duty imposed on the employee as a result of his tippee status would be attributed also. Thus, primary liability would exist, as in the SEC's action against the First Boston Corp. In that settled proceeding, First Boston learned confidential information about an increase in a client's loss reserves through its Corporate Finance department. That information made its way to the head trader in the firm's Equity Trading department (a managing director), who caused the firm to sell the client's stock. First Boston consented to disgorgement of profits of $132,138, a penalty of $264,276 and an undertaking to review and improve if necessary its procedures for handling confidential information.
SAC presumably will try to argue that the employees who engaged in insider trading on its behalf were unauthorized rogue traders. Hence, the indictment takes some considerable pains to describe how SAC created an environment in which insider trading was pervasive and internal controls were lacking.
Keith Paul Bishop raises an interesting point:
Yesterday’s post concerned the attorney-client privileged issues in Vice Chancellor J. Travis Laster’s recent decision in Kalisman v. Friedman, 2013 Del. Ch. LEXIS 100 (April 17, 2013). I found another statement in the decision even more intriguing -
When a director serves as the designee of a stockholder on the board, and when it is understood that the director acts as the stockholder’s representative, then the stockholder is generally entitled to the same information as the director.
This statement appears to be at odds with the statements of Chancellor William T. Allen in Holdgreiwe v. The Nostalgia Network, Inc., 1993 Del. Ch. LEXIS 71 (April 29, 1993), a case cited by Vice Chancellor Laster in Kalisman (albeit for a different proposition). InHoldgreiwe, the corporation sought to condition inspection by one of its directors, Daniel Holdgreiwe, upon the signing of a confidentiality agreement. Mr. Holdgreiwe was a nominee of one of the corporation’s stockholders, Concept Communications, Inc. Chancellor Allen declined to impose that condition, saying:
But conditioning Holdgreiwe’s right to inspect Nostalgia’s corporate books and records on his entry into an agreement binding him not to disclose any of the information he obtains to any third parties, including AVI [an affiliate of Concept] and Concept, seems to me to add little. He is already under an obligation to maintain the confidences of Nostalgia; to use its confidential information only to inform discussion among directors and action by the board or a committee. Disclosure of such information to AVI is a violation of duty whether or not an undertaking is entered. Thus, such an undertaking seems unnecessary.
On the one hand, Chancellor Allen seems to be saying that information conveyed to a director may be used only for the purposes of the corporation. On the other hand, Chancellor Allen quite conspicuously (and I assume intentionally) refers solely to AVI when speaking about a potential breach of fiduciary duty (Concept, not its affiliate AVI, had elected Mr. Holdgreiwe).
It's an interesting issue of state corporate law, but don't forget that it also raises serious federal insider trading questions. Remember the debate a few months ago about whether hedge funds could compensate their director nominees? Suppose a hedge fund nominated Bainbridge to be a director of Acme. Bainbridge is elected. In addition to his director fee from Acme, Bainbridge also gets a performance-based annual bonus from the hedge fund. Bainbridge provides material nonpublic information to the hedge fund, which then uses it to trade. Has Bainbridge made an illegal tip?
In order to hold Bainbridge liable, the government would need to show that he (a) disclosed material nonpublic information to the fund (b) in return for a personal benefit (c) and, probably, expecting the fund to trade. Does the bonus count as the requisite personal benefit (even if there is no explicit quid pro quo)? Could the government argue Bainbridge gets an enhanced reputation, which would constitute a nonpecuniary benefit?
BTW, with respect to state law, I think it probably matters whether you are dealing with a close or public corporation. In a close corporation, if one shareholder gets to name a director and the other shareholders make an informed agreement to allow the director to share information with the shareholder, I don't see a problem. But in the public corporation, I think the law probably should require confidentiality.
How did Rajat Gupta, who belonged to the highest echelons of corporate America, the golden boy of Indian Americans, get convicted of insider trading? How did Rajaratnam get tips on companies like Intel? Anita Raghavan's book The Billionaire's Apprentice tracks one of the biggest cases — and its riveting characters — to shake Wall Street ...
The WSJ reports that:
On the morning of March 15, stocks stumbled on news that a key reading of consumer confidence was unexpectedly low.
One group of investors already knew that. They got the University of Michigan's consumer report two seconds before everyone else. ...
The early look at the consumer-sentiment findings comes from Thomson ReutersCorp. TRI.T -0.18% The company will pay the University of Michigan $1.1 million this year for rights to distribute the findings, according to the university. Next year, it will pay $1.2 million.
In turn, Thomson Reuters's marketing materials say the firm offers paying clients an "exclusive 2-second advanced feed of results…designed specifically for algorithmic trading."
The Journal found a law professor to criticize this activity:
This is a "blind spot" in U.S. law, said Richard Painter, a former Republican White House ethics lawyer. Groups, he said, should "not be allowed to selectively disclose market-moving data to people who pay more money—that is not right."
Sadly, however, the Journal failed to find a law professor to defend the practice. Accordingly, I will step into the breach.
At the outset, I should acknowledge that Prof. Painter and I are old friends. He's a very, very smart guy with a vast store of knowledge of both ethics and securities law. But I think he's wrong here.
First, this sort of trading activity is clearly legal. The Supreme Court long ago rejected the argument--which seems implicit in Painter's objection--that insider trading regulation should seek to ensure that all investors had equal access to information. As the late Supreme Court Justice Lewis Powell explained in Dirks v. SEC:
We were explicit in Chiarella in saying that there can be no duty to disclose where the person who has traded on inside information “was not [the corporation’s] agent, ... was not a fiduciary, [or] was not a person in whom the sellers [of the securities] had placed their trust and confidence.” Not to require such a fiduciary relationship, we recognized, would “depar[t] radically from the established doctrine that duty arises from a specific relationship between two parties” and would amount to “recognizing a general duty between all participants in market transactions to forgo actions based on material, nonpublic information.”
Here, the people who trade on the basis of the information they bought from Thomson Reuters are not agents or any other species of fiduciary with respect to the corporation in whose securities they trade or the investors with whom they trade. (This is even more so where they trade in derivatives based on the whole market rather than individual corporate stocks.) As the Journal thus correctly reported:
Even as securities rules bar companies from selective data disclosure, and as authorities vigorously pursue insider trading in all its forms, no law prevents investors from trading on nonpublic information they have legally purchased from other private entities. Trading would be illegal only if the information was passed through a breach of trust, said securities lawyers.
"If someone gives you permission to use the information, then there is no problem," said Steve Crimmins, a former Securities and Exchange Commission enforcement official now at law firm K&L Gates LLP.
Painter knows this, of course, which is why he called it a "blind spot." But is he correct in implying that the law should be changed? No.
If you believe, as I do (see this article), that the law of insider trading is a species of property rights in information, then insider trading ought to be illegal only where the inside trader's use of the infiormation involved a breach of fiduciary duty, misrepresentation, or theft. Where the source of the information voluntarily sells information to end users, there has been no violation of the source's property right in that information and, hence, no basis for liability.
As Judge Ralph Winter explained in his separate opinion in United States v. Chestman:
Information is ... expensive to produce, and, because it involves facts and ideas that can be easily photocopied or carried in one’s head, there is a ubiquitous risk that those who pay to produce information will see others reap the profit from it. Where the profit from an activity is likely to be diverted, investment in that activity will decline. If the law fails to protect property rights in commercial information, therefore, less will be invested in generating such information.
Conversely, if the law does not allow producers of information to profit from the sale of that information, there also will be less invested in producing such information. The Supreme Court recognized this point in Dirks, where it explained that insider trading law must be carefully applied so as to avoid punishing market analysts:
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. It is commonplace for analysts to “ferret out and analyze information,” … 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.
Precisely the same analysis applies here. If this so-called "blind spot" were to be patched with legislation banning such transactions, the effect will not be to ensure that all investors have equal access to this sort of information. Instead, the effect will be that nobody will have access to it because such information simply won't be produced:
Richard Curtin, an economist who runs the university's survey, said he knows the deal gives an advantage to select investors.
"Hardly anyone would pay for it if they didn't see a profit motive," Mr. Curtin said. Later, he added: "This research is totally funded by private sources for the benefit of scientific analysis, to assess public policy, and to advance business interests. Without a source of revenue, the project would cease to exist and the benefits would disappear."
And that would help nobody.
Today's mail brought an advance copy of the Research Handbook on Insider Trading, edited by yours truly.
In most capital markets, insider trading is the most common violation of securities law. It is also the most well known, inspiring countless movie plots and attracting scholars with a broad range of backgrounds and interests, from pure legal doctrine to empirical analysis to complex economic theory. This volume brings together original cutting-edge research in these and other areas written by leading experts in insider trading law and economics.
The Handbook begins with a section devoted to legal issues surrounding the US's ban on insider trading, which is one of the oldest and most energetically enforced in the world. Using this section as a foundation, contributors go on to discuss several specific court cases as well as important developments in empirical research on the subject. The Handbook concludes with a section devoted to international perspectives, providing insight into insider trading laws in China, Japan, Australia, New Zealand, the United Kingdom and the European Union.
This timely and comprehensive volume will appeal to students and professors of law and economics, as well as scholars, researchers and practitioners with an interest in insider trading.
Table of Contents (below the fold)
Yahoo Finance reports:
A year ago President Obama signed the so-called STOCK Act. The point of the act was to allow the public to see for themselves if members of Congress and their employees were trading on material, non-public information. "The STOCK Act: Bans Members of Congress from Insider Trading" was the bolded headline at the top of a lengthy and self-congratulatory press release.
Last Monday the White House website took the guts out of the STOCK Act in one run-on sentence under the headline "Statement by the Press Secretary on S. 76." Those so inclined are invited to read the memo themselves. The gist is that disclosures will no longer be practically available for all employees but only for the elected officials, which means staffers, lobbyists, employees, aides and anyone who works for or is close to a serving politician can do whatever they want. Corrupt officials could theoretically still dish insider info with little fear of discovery — it's just hard for them to trade off of the information themselves.
The idea of transparency is to remove doubt about conflicts of interest and malfeasance, real or imagined. When the rules are quietly changed to such a degree, it defeats the purpose entirely.
On the one hand, the STOCK Act's prohibition on insider trading remains intact, which is a good thing. On the other hand, I agree completely with the author that transparency via disclosure was essential. As Justice Brandeis that sunlight is the best disinfectant and electric light the best policeman.
The scandals and routine abuses Peter Schweizer exposed in Throw Them All Out cried out for reform. Congress was dragged kicking and screaming into reform, but now has started chopping back on it. Time to hold their feet to the fire yet again.
Two affiliates of SAC Capital, the giant hedge fund, settled insider trading charges with the Securities and Exchange Commission for $614 million on Friday, in what the agency said was the biggest ever settlement for such cases.
The settlements spare SAC’s founder, the billionaire Steven A. Cohen, who hasn’t been charged with wrongdoing. Mr. Cohen, one of the most successful hedge fund managers in the world, has long been considered a target of federal investigators.
David Zarig comments:
The case against Cohen always looked pretty strong to me, and he's certainly not too big to jail, like, say, HSBC. But still, it's just an insider trading case, and I have found this indictment of the "after he heard from x, he phoned y" method of proof, which would be combined with, presumably, testimony from a former employee about a conversation had with Cohen, to be pretty convincing.
No what will it do to SAC's business?
Interesting paper just posted to SSRN:
Insider trading has received a great deal of bad press in recent decades. Nearly every article in the popular press that has been written about it views the practice in a negative light. However, the economics and legal literature are mixed on the issue. This article examines the economics and legal literature and applies several sets of ethical principles with the goal of determining when insider trading constitutes unethical conduct and when it should be prohibited. The conclusion is that the key to determining when the practice should be prohibited should not depend upon a utilitarian analysis because utilitarian approaches cannot provide clear guidance. A better approach would be to determine whether a fiduciary duty has been breached or whether rights have been violated.
Don Langevoort has posted a very interesting article on the questions of "how or why did the insider trading prohibition survive the retrenchment that happened to so many other elements of Rule 10b-5?," which is linked and summarized here.
Langevoort goes on to observe that:
The Supreme Court’s strange and intellectually ungainly judicial commitment to assertive insider trading regulation, even by some fairly conservative judges, shows how powerful a totemic symbol the prohibition of insider trading has become in “branding” the American securities markets as supposedly open and fair, and American securities regulation as the investors’ champion. Insider trading regulation had already taken on an expressive value far beyond its economic importance, which judges were reluctant to undercut.
My argument is that the Supreme Court embraced the continuing existence of the “abstain or disclose” rule, and tolerated constructive fraud notwithstanding its new-found commitment to federalism, because it accepted the central premise on which the expressive function of insider trading regulation is based: manifestations of greed and lack of self-restraint among the privileged, especially fiduciaries or those closely related to fiduciaries, threaten to undermine the official identity of the public markets as open and fair. The law effectively grants an entitlement to public traders that the marketplace will not be polluted by those kinds of insiders.
As an explanation of what the Supreme Court might have been thinking when it developed the modern insider trading prohibition, Langevoort's argument has much to commend it.
Assuming he's right about that question, however, it leaves open the question of whether the SCOTUS' policy choice makes any sense. I don't think so. I've tackled this issue in several places, most notably in The Law and Economics of Insider Trading: A Comprehensive Primer (February 2001). Available at SSRN: http://ssrn.com/abstract=261277.
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.
Let me repeat: If any investors believe that the SEC’s enforcement actions drove insider trading out of the markets, they are beyond mere legal help. And, if the Supreme Court believes that investors believe that, the Court needs help.
Just read two different articles on the titular topic. A student note by Joseph Pahl (106 Nw. U. L. Rev. 1849) says no:
Rule 10b5-2(b)(1) overreaches the statutory authority of the SEC by creating liability under § 10(b) without the existence of deception or manipulation. It is unreasonable to interpret a promise not to disclose confidential information as a simultaneous agreement not to use that information (while keeping it confidential) for an individual's personal benefit. The acts of disclosure and use are temporally separate acts, and it would be perverse to believe that, when an individual agrees not to disclose a piece of information, it is inherently deceitful to use that information for his personal benefit while maintaining confidentiality. ...
Assuming arguendo that 10b5-2(b)(1) is not contrary to the courts' interpretation of the meaning of the statute, the rule does not pass the second prong of the Chevron test: Rule 10b5-2(b)(1) is “arbitrary, capricious, or manifestly contrary to the statute.” ... A confidentiality agreement alone fails to create a situation where a deceptive act is possible by trading without some further fiduciary or fiduciary-like relationship.
I am highly sympathetic to that line of argument, but Professor Steven Cleveland argues that (65 Fla. L. Rev. 73):
To date, commentators [including yours truly, as Cleveland notes] have argued against the rule's validity by applying the Supreme Court's securities law jurisprudence without considering the role of administrative law-despite the Court's comments that the pertinent statute is ambiguous, despite express delegation of rulemaking authority by Congress to the Commission, and despite developments in administrative law subsequent to the Court's relevant securities law decisions. By not considering the role of administrative law, commentators have approached the rule with undue skepticism. Administrative law principles dictate judicial deference to the Commission's rule. The Commission once commanded deference from courts. The time has come to resurrect that deference.
Cleveland makes a thoughtful and reasoned argument. But in my judgment, however, the time for deference has not yet come.
I will once again quote Michael Greve:
I’m teaching something called, fraudulently, administrative “law.” Believe you me: nothing in that corpus juris poses any meaningful constraint on government. E.g., I’m supposed to teach and therefore do teach that judges must bow to any bureaucrat’s take on the law (unless it’s completely nuts) because otherwise the D.C. Circuit might end up running the country and good sense and lawful government might break out.
I will also note that deference ought to be earned rather than given by Supreme Court fiat. To wit, consider Business Roundtable v. SEC, 647 F.3d 1144 (DC Cir. 2011):
Under the APA, we will set aside agency action that is “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” ...
We agree with the petitioners and hold the Commission acted arbitrarily and capriciously for having failed once again—as it did most recently in American Equity Investment Life Insurance Company v. SEC, 613 F.3d 166, 167–68 (D.C.Cir.2010), and before that in Chamber of Commerce, 412 F.3d at 136—adequately to assess the economic effects of a new rule. Here the Commission inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commenters.
I believe close examination of the relevant history fo the SEC's adoption of Rule 10b5-2 will reveal precisely the same shortcomings that mandated striking down the proxy access rule. Compare, e.g., both the majority and Judge Winter's separate opinions in the old Chestman case to the proposing and adopting releases for Rule 10b5-2. The first pair is thoughtful, analytical, reasoned. The second one isn't.