I'm teaching insider trading in class today. It'll take me about 100 minutes. Here, in contrast, Yale law prof Jonathan Macey explains it in just over 12 minutes:
The insider-trading lawsuit against Mark Cuban will continue after a federal judge turned down the billionaire Dallas Mavericks owner's attempt to dismiss the government's case as unproven.
U.S. District Court Judge Sidney Fitzwater's ruling late Monday means that the case is likely to be decided by a jury of seven women and three men who heard Cuban testify for two days.
The Securities and Exchange Commission charges that Cuban violated a confidentiality agreement and unloaded his shares in a Canadian search-engine company in 2004 after learning that the company planned a stock offering that would reduce the value of his $7.5 million stake. The government says Cuban avoided $750,000 in losses by selling his shares before the offering was announced.
Much of Cuban's testimony Monday repeated what he said last week — that he never agreed to keep information about the offer confidential and saw no reason why he couldn't sell his shares in Mamma.com Inc.
We've covered the case in detail here at PB.com over the years. In the original post back in 2008, I wrote:
The SEC today announced that:
The Securities and Exchange Commission today charged Dallas entrepreneur Mark Cuban with insider trading for selling 600,000 shares of the stock of an Internet search engine company on the basis of material, non-public information concerning an impending stock offering.
The Commission's complaint, filed in the U.S. District Court for the Northern District of Texas, alleges that in June 2004, Mamma.com Inc. invited Cuban to participate in the stock offering after he agreed to keep the information confidential. The complaint further alleges that Cuban knew that the offering would be conducted at a discount to the prevailing market price and that it would be dilutive to existing shareholders.
Within hours of receiving this information, according to the complaint, Cuban called his broker and instructed him to sell Cuban's entire position in the company. When the offering was publicly announced, Mamma.com's stock price opened at $11.89, down $1.215 or 9.3 percent from the prior day's closing price of $13.105. According to the complaint, Cuban avoided losses in excess of $750,000 by selling his stock prior to the public announcement of the offering.
You can read the complaint here.
My review of the complaint suggests that the SEC has a pretty weak case, even assuming they can prove out the facts alleged, in large part because they'll need to find a court willing to give the rules a liberal construction on one key point.
The central legal issue in this case likely will be whether Cuban assumed a fiduciary obligation of confidentiality with respect to Mamma.com.
As I explain in my book on insider trading (Securities Law: Insider Trading (Turning Point Series)), there are two theories on which someone may be held liable for insider trading: (1) The "classical" disclose or abstain rule. In Dirks v. SEC, 463 U.S. 646, 654?55 (1983), the Supreme Court explained the key limit on that theory:
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."
Based on the facts as alleged, the most likely scenario is that Cuban will be charged with being a so-called "constructive insider." As Dirks explained:
Under certain circumstances, such as where corporate information is revealed legitimately to an underwriter, accountant, lawyer, or consultant working for the corporation, these outsiders may become fiduciaries of the shareholders. The basis for recognizing this fiduciary duty is not simply that such persons acquired nonpublic corporate information, but rather that they have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes.... For such a duty to be imposed, however, the corporation must expect the outsider to keep the disclosed nonpublic information confidential, and the relationship at least must imply such a duty.
Mamma.com clearly expected Cuban to keep the information confidential, but did their relationship "imply such a duty"? Cuban, after all, is not "an underwriter, accountant, lawyer, or consultant working for the corporation." Nor was his stock opwnership enough; at 6.3%, he probably would not be deemed a controlling shareholder.
This is a potential real problem for the SEC. 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.
(2) The misappropriation theory of insider trading liability is an alternative basis for liability, under which the defendant need not owe a fiduciary duty to the investor with whom he trades. Likewise, he need not owe a fiduciary duty to the issuer of the securities that were traded. Instead, the misappropriation theory applies when the inside trader violates a fiduciary duty owed to the source of the information. As eventually refined, the misappropriation theory imposed liability on persons who (1) misappropriated material nonpublic information (2) thereby breaching a fiduciary duty or a duty arising out of a similar relationship of trust and confidence and (3) used that information in securities transaction, regardless of whether they owed any duties to the shareholders of the company in whose stock they traded.
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. But my guess is that a court will defer to the agency on its interpretation of the statute.
Alternatively, the SEC may be able to show that the Mamma.com CEO and Cuban had a pattern or practice of sharing confidences such that the recipient of the information knows or reasonably should know that the speaker expects the recipient to maintain the information's confidentiality. This would also satisfy Rule 10b5-2. In addition, theChestman case suggested that such a pattern could also give rise to fiduciary relationships, at least among family members.
Finally, WTF was he thinking? According to the SEC, Cuban saved a whopping $750,000. According to Wikipedia: "As of 2007, Cuban is #133 on Forbes' "World's Richest People" list, with a net worth of $2.8 billion."
This wouldn't be the first time greed made an iincredibly wealthy person do something stupid over what amounts, from their perspective to chump change. (Remember Martha Stewart, who saved $45,673 by selling her Imclone shares?)
But I really don't understand the psychology in most of these cases. You're rich. You can afford to take a hit.
In Cuban's case, however, I suspect it was not greed but rather his legendary temper that did him in. The PIPE transaction Mamma.com planned would have involved the issuance of new shares at a below market price. It would have diluted the economic value and voting rights of Cuban and the other pre-PIPE investors. The complaint makes clear that Cuban was furious about the planned sale. His anger led him to a rash act, which now could result in serious civil fines. Whether the Justice Department will pursue criminal charges, as well, remains to be seen.
On his blog, Cuban quoted a press announcement:
Mark Cuban today responded to a civil complaint filed by the United States Securities and Exchange Commission in the United States District for the Northern District of Texas, Dallas Division. In its complaint, the Commission charges that Mr. Cuban engaged in violations of the federal securities laws in connection with transactions in the securities of Mamma.com Inc.
This matter, which has been pending before the Commission for nearly two years, has no merit and is a product of gross abuse of prosecutorial discretion. Mr. Cuban intends to contest the allegations and to demonstrate that the Commission's claims are infected by the misconduct of the staff of its Enforcement Division.
Mr. Cuban stated, "I am disappointed that the Commission chose to bring this case based upon its Enforcement staff's win-at-any-cost ambitions. The staff's process was result-oriented, facts be damned. The government's claims are false and they will be proven to be so."
In a followup post, I noted that:
On his blog,Cuban today quotes a press release from his legal counsel claiming there was no such agreement:
The SEC knows their case centers on one telephone conversation between two individuals- 4 years ago. The SEC claims there was an agreement between these parties to the conversation to keep certain information confidential. We interviewed Guy Faure, the former CEO of Mamma.com Inc., with whom the SEC claims Mr. Cuban made an agreement. We had a court reporter transcribe the interview. There was no agreement to keep information confidential.
Cuban's blog post then goes on to quote from the transcript of the interview.
If there was no confidentiality agreement, Cuban ought to prevail. As I explained in my book on insider trading:
Although [the leading Supreme Court precedent in Dirks v. SEC] clearly requires that the recipient of the information in some way agree to keep it confidential, courts have sometimes overlooked that requirement. In SEC v. Lund, for example, Lund and another businessman discussed a proposed joint venture between their respective companies. In those discussions, Lund received confidential information about the other's firm. Lund thereafter bought stock in the other's company. The court determined that by virtue of their close personal and professional relationship, and because of the business context of the discussion, Lund was a constructive insider of the issuer. In doing so, however, the court focused almost solely on the issuer's expectation of confidentiality. It failed to inquire into whether Lund had agreed to keep the information confidential.
Lund is usefully contrasted with Walton v. Morgan Stanley & Co. 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." Although Walton was decided under state law, it has been cited approvingly in a number of federal insider trading opinions and is generally regarded as a more accurate statement of the law than Lund. Indeed, a subsequent case from the same district court as Lund essentially acknowledged that it had been wrongly decided:
What the Court seems to be saying in Lund is that anytime a person is given information by an issuer with an expectation of confidentiality or limited use, he becomes an insider of the issuer. But under Dirks, that is not enough; the individual must have expressly or impliedly entered into a fiduciary relationship with the issuer.
Even this statement does not go far enough, however, because it does not acknowledge the additional requirement of an affirmative assumption of the duty of confidentiality.
So if Cuban's right on the facts, there should be no liability.
But that raises another question: Should Cuban be conducting his defense in public on his blog?
The SEC told the WSJ that:
Scott Friestad, deputy director of the SEC's enforcement division, said: "We're not going to comment on anything Mr. Cuban or his lawyers have to say on Mr. Cuban's blog and we look forward to presenting our case in court."
I still think Cuban's right on the law, but the federal courts have proven to be essentially ineducable on this point.
I recently ran across an article by John Coffee (2013 Colum. Bus. L. Rev. 281) in which he opined that:
SEC v. Cuban ... accepted in principle that a legal duty can arise by contract, whose breach would violate Rule 10b-5. SEC v. Cuban, 634 F. Supp. 2d 713 (N.D. Tex. 2009). The defendant had claimed that only fiduciary breaches recognized under state law could support a violation of Rule 10b-5.Id. at 726. Conservative law professors have long argued the thesis that only such a state law grounded violation could support a Rule 10b-5 violation. See Stephen A. Bainbridge, Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Wash. & Lee L. Rev. 1189, 1267 n.320 (1995). But Rule 10b5-2 today recognizes that a “duty of trust or confidence” can be grounded on a contract or an agreement “to maintain information in confidence.” See Rule 10b5-2(b)(1), 17 C.F.R. § 240.10b5-2(b)(1) (2013). Decisions to date have largely upheld the rule. See SEC v. Yun, 327 F.3d 1263, 1273 (11th Cir. 2003)(recognizing that “a breach of an agreement to maintain business confidences would also suffice” to support insider trading liability); SEC v. Lyon, 529 F. Supp. 2d 444, 452-53 (S.D.N.Y. 2008). However, in SEC v. Cuban, the court drew a tortured distinction between agreeing to maintain confidentiality and agreeing not to trade. Cuban, 634 F. Supp. 2d at 729-31. In its view, Rule 10b5-2(b)(1) improperly “attempts to predicate misappropriation theory on a mere confidentiality agreement lacking a non-use component.” Id. at 730-31. This distinction between agreeing to maintain confidentiality and agreeing not to trade was, however, viewed skeptically by the Fifth Circuit, which vacated and remanded. See SEC v. Cuban, 620 F.3d 551 (5th Cir. 2010). In United States v. Whitman, the district court went well beyond Cuban and held that Rule 10b-5 is not grounded on state law theories of fiduciary duty, but rather on federal common law. United States v.Whitman, No. 12 Cr. 125 (JSR), 2012 U.S. Dist. LEXIS 163138, at *14-16 (S.D.N.Y. Nov. 14, 2012). To the extent that federal law controls, SEC rules could do much more to generalize or expand the scope of the insider trading prohibition.
There are a couple of things going on here. First, can an agreement to keep information confidential create the requisite relationship of trust and confidence necessary to sustain an insider trading conviction? The SEC claims that it can and incorporated that assertion into Rule 10b5-2. Coffee is correct that the cases have mostly upheld the Rule, which isn't terribly surprising given the deference courts typically give agencies. Along with several other prominent securities law experts, however, I filed an amicus brief in the Cuban case arguing that SEC Rule 10b5-2 got it wrong. I've also blogged about the problem with using an agreement as the basis of an insider trading conviction repeatedly, most notably here and here.
Second, while it is true that the Whitman case treats insider trading as a species of federal common law, Judge Rakoff in that case and Coffee here erred by stopping at that point. (I blogged a response to the Whitman case back when it came out.)
In crafting a rule of decision for federal common-law cases, courts can either create a unique federal standard or incorporate state law into the federal rule. In the latter case, the cause of action remains federal, but the content of federal law is supplied by the incorporated state law principles. The decision to incorporate state law depends upon whether there are important federal interests that would be adversely affected by doing so. If so, the court will create a uniform federal standard, but if not, the court may incorporate state law.
As such, you don't simply announce that a rule is federal common law and call it a day. You have to go on to decide if federal common law should subsume state law.
In order to decide whether state fiduciary duties should be incorporated into the federal insider trading prohibition, we thus must ask two questions: Would incorporation adversely affect prosecution of insider trading under the federal securities laws and, if so, would any identifiable policy goal of those laws be frustrated thereby?
In an article Judge Rakoff cited (Stephen M. Bainbridge, Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Wash. & Lee L.Rev. 1189 (1995)), but seemingly did not read closely, I exhaustively reviewed the rules on creating federal common law and concluded that they strongly support treating the federal prohibition of insider trading as an empty shell that has no force or substance until it has been filled with state law fiduciary duty concepts. This conclusion draws support from three prongs: (1) the rules governing the making of federal common law, (2) the Supreme Court's federalism jurisprudence, especially in the context of the securities laws' intersection with state corporate law, and (3) the public policy rationale for regulating insider trading. The argument stretches across 20-plus pages of a very long article, so I'll ask the interested reader to go to the article rather than extending this post.
I recently ran across an article by George Dent (38 Del. J. Corp. L. 247), in which he criticized yours truly's approach to insider trading policy:
Stephen Bainbridge argues for assigning the property right to the corporation. [FN193] This argument, however, raises the question: how can a corporation exploit that right, especially with respect to its own stock? [FN194] Bainbridge never addresses this question. [FN195] If the corporation reassigns the right to managers, we have all the problems already discussed. [FN196]
[FN194]. Sometimes inside information creates opportunities for profit from trading the securities of another company. For example, if Raider decides to bid to acquire Target's stock at a premium over its current market price, Raider could profit by first buying some of Target's stock at its current price and then profiting from the expected increase in that price when the bid is announced. See Bainbridge, supra note 1, at 655, 657-58 (describing pre-announcement purchases by raiders) [Citing to Stephen M. Bainbridge, Corporation Law and Economics (2002).]
[FN195]. Id. at 655. [FN196]. See supra Part V.
[FN197]. See Bainbridge, supra note 156, at 1218, 1223. [It's unclear what he's citing here. The only cite to my work in footnote 156 is a jump cite back to the book cited in note 1. Given the page references, however, he's probably citing to Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Wash. & Lee L. Rev. 1189, 1256 (1998).]
Fair enough. Although I have danced with that question, I have never given an explicit answer. Moreover, for reasons discussed below, I don't think I need to answer that question in order to defend a property rights-based understanding of insider trading law. Hence, I still will not answer it. I'll just explain why not.
First, it is true, of course, that I believe that that the federal insider trading prohibition is most easily justified as a means of protecting property rights in information.
Second, it should go without saying (but given Dent's recent history of attacking my scholarship as "deluded", probably needs to be made explicit), that I do not approve of fraud. So when a corporation trades in its own securities, whether buying or selling, I think the corporation should be liable if it withholds material nonpublic information. This is true, I think, even if one has doubts about the utility of the SEC's mandatory disclosure regime:
The issue is not whether the government should prohibit securities fraud. One can tell a very plausible behavioral economics story about the cognitive foibles of investors that make them vulnerable to securities fraud. A complete behavioral analysis of securities regulation would require one to evaluate that story. As we have seen, however, prevention of securities fraud is not a very plausible explanation for the mandatory disclosure regime. If one wants to prevent issuers from taking advantage of cognitive errors by investors, the appropriate place to do so is in the anti-fraud regime not the disclosure regime. [Stephen M. Bainbridge, Mandatory Disclosure: A Behavioral Analysis, 68 U. Cin. L. Rev. 1023 (2000).]
Third, should the corporation be able to authorize its employees to trade on the basis of material nonpublic information? In his case book, for example, Michael Dooley points out that insider trading can be treated as a compensation question, which may lead to disclosure problems. Insider compensation is one of the many items of mandatory disclosure under the SEC's regulations. Failure to disclose insider trading profits thus might be treated as a material omission, which would give rise to a claim for fraud. This does not necessitate a prohibition of insider trading, however, just enforcement (or, at most, expansion) of the Exchange Act's existing rules on disclosure of insider trading profits.
Here we must pause to address an ambiguity in Dent's article. The article begins:
Although insider trading is illegal and widely condemned, a stubborn minority still defends it as an efficient method of compensating executives and spurring innovation. [FN1] However, these defenses crucially assume that the wealth of individual insiders constrains the scope of insider trading. [FN2]
[FN1] A number of state courts continue to hold that insider trading breaches no fiduciary duty. See Stephen M. Bainbridge, Corporation Law and Economics 572 n.58 (2002); see also Henry Manne, Insider Trading and the Stock Market 172-73, 178 (1966) (categorizing the perceived danger posed by insider trading as generally exaggerated and noting how businesses may actually benefit from the use of inside information by government officials); Dennis W. Carlton & Daniel R. Fischel, The Regulation of Insider Trading, 35 Stan. L. Rev. 857, 860 (1983) (arguing that insider trading is, in many markets, irregularly enforced, and that the law, in promoting enforcement, ignores the economic realities of insider trading); Darren T. Roulstone, The Relation Between Insider-Trading Restrictions and Executive Compensation, 41 J. Acct. Research 525, 549 (2003) (“[I]nsider trading rewards and motivates executives.”).
[FN2]. See Bainbridge, supra note 1, at 591 (“[T]he insider's compensation is limited by the number of shares he can purchase. This, in turn, is limited by his wealth.”); see also Manne, supra note 1, at 173 (discussing the parameters of inside information usage by government employees).
As I read that, Dent seems to be including me in his "stubborn minority." If so, that's just not true. After all, right there on page 605 of my 2002 treatise it says "insider trading is an inefficient compensation scheme." And on the same page I say that the compensation argument "appears to founder." Plus, back on pages 591-92 I rehearse the arguments against using insider trading as compensation. But if that's not clear enough, here goes: insider trading cannot be justified as a way of compensating employees. Period.
This leads us back, however, to the question of whether the corporation should be able to authorize its employees to trade on the basis of material nonpublic information. After all, there are lots of other inefficient managerial compensation schemes. Hence, to say that insider trading cannot be justified as a compensation scheme is not the same as saying insider trading should be banned because it is a bad way of compensating managers.
Although Dent probably thinks that a negative answer to the authorized trading question would undermine my view that the property rights approach is the only viable theory for regulating insider trading, that would not be true. As I observed in Insider Trading, in III Encyclopedia of Law & Economics 772 (Edward Elgar Publishing Ltd. 2000):
For law and economics supporters of the insider trading prohibition, an interesting question is whether the corporate employer should be allowed to authorize its agents to inside trade. Because most property rights are freely alienable, treating confidential information as a species of property suggests that the information’s owner is presumptively entitled to decide whether someone may use it to inside trade. In other words, the insider trading prohibition arguably should be treated as simply a special case of the laws against theft.
Another way of phrasing the question is to ask whether the prohibition of insider trading should be a default or a mandatory rule. Default rules in corporate law are analogous to alienable property rights. Just as shareholders generally are protected by the doctrine of limited liability unless they give a personal guarantee of the corporation’s debts, patentholders have exclusive rights to their inventions unless they authorize another’s use by granting a license. Continuing the analogy, mandatory rules in corporate law are comparable to inalienable property rights. Just as corporate law proscribes vote buying, the law prohibits one from selling one’s vote in a presidential election.
So phrased, the insider trading problem becomes a subset of one of the fiercest debates in the corporate law academy; namely, the extent to which mandatory rules are appropriate in corporate law. A detailed analysis of this debate is beyond this essay’s scope. Accordingly, it perhaps suffices to observe that the question of whether the insider trading prohibition should be cast as an alienable or an inalienable property right remains open. See generally Fischel (1984) ; Macey (1984) ; Ulen (1993).
Admittedly, not staking out a firm position. I have stated that, in some contexts (namely, lawyer client) the insider trading rule should be mandatory. I think that argument extends to the employment context as well, but I don't believe I need to stake out a final conclusion on that issue here. All I need do here is explain why a property rights-based approach to understanding insider trading is not inconsistent with a mandatory rule.
So, no, I have not answered his question. But so what?
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?