Market research by analysts and professional investors makes important contributions to the capital markets by promoting the liquidity and efficiency of those markets. As Professors Gilson and Kraakman explain, there are four principal mechanisms by which markets process information and set equilibrium prices in response to new information:
First, market prices immediately reflect information that all traders know, simply because this information necessarily informs all trades, just as perfect markets theorists assumed (“universally-informed trading”). Second,information that is less widely known but nonetheless public, is incorporated into share prices almost as rapidly as information know to everyone through the trading of savvy professionals (“professionally-informed trading”). Third, inside information known to only a very few traders would find its way into prices more slowly, as uninformed traders learned about its content by observing tell-tale shifts in the activity of presumptively informed traders or unusual price and volume movements (“derivatively-informed trading”). Finally,information known to no one might be reflected, albeit slowly and imperfectly, in share prices that aggregated the forecasts of numerous market participants with heterogeneous information (“uninformed trading”).
Take away the ability of professional investors and analysts to ferret out information and we weaken both the professionally-informed trading and the derivatively-informed trading mechanisms. The result will be less liquid markets with greater price anomalies.
The late US Supreme Court Justice Lewis Powell was aware of the valuable contributions market research makes and deeply concerned that an over expansive prohibition of insider trading would deter legitimate market research. Hence, he wrote in Dirks v. SEC, 463 U.S. 646 (1983), that:
Imposing [insider trading liability] solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market. [Footnote 17] It is commonplace for analysts to "ferret out and analyze information," 21 S.E.C. Docket at 1406, and this often is done by meeting with and questioning corporate officers and others who are insiders. And information that the analysts obtain normally may be the basis for judgments as to the market worth of a corporation's securities. The analyst's judgment in this respect is made available in market letters or otherwise to clients of the firm. It is the nature of this type of information, and indeed of the markets themselves, that such information cannot be made simultaneously available to all of the corporation's stockholders or the public generally.
[Footnote 17] The SEC expressly recognized that "[t]he value to the entire market of [analysts'] efforts cannot be gainsaid; market efficiency in pricing is significantly enhanced by [their] initiatives to ferret out and analyze information, and thus the analyst's work redounds to the benefit of all investors." 21 S.E.C. Docket at 1406. The SEC asserts that analysts remain free to obtain from management corporate information for purposes of "filling in the interstices in analysis'. . . ." Brief for Respondent 42 (quoting Investors Management Co., 44 S.E.C. at 646). But this rule is inherently imprecise, and imprecision prevents parties from ordering their actions in accord with legal requirements. Unless the parties have some guidance as to where the line is between permissible and impermissible disclosures and uses, neither corporate insiders nor analysts can be sure when the line is crossed. Cf. Adler v. Klawans, 267 F.2d 840, 845 (CA2 1959) (Burger, J., sitting by designation).
Accordingly, the Dirks case confirmed the basic principle that insider trading liability does not arise simply because the defendant had more information than other market actors. Instead, liability arises only when the defendant breached a fiduciary duty by trading on the basis of that information or by tipping the information to a corporate outsider (I oversimplify somewhat). See generally my book Securities Law: Insider Trading (Turning Point Series)
"Just saying, we want better information, even we want information no one else has, there's absolutely nothing illegal about that," said Christopher Clark, a former federal prosecutor who is now a defense lawyer. "The only illegality is when it comes in breach of a fiduciary duty or in another similar duty that requires them not to use the information."
As I document in my Insider Trading text, the SEC hates the Dirks rule. The SEC has always wanted a rule of equality of access: If you have more information than anybody else, you can't trade. The SEC has consistently by rule and by positions it takes in litigation sought to undermine the Dirks regime. As Peter Wallison observed, for example, this attitude drove the adoption of Reg FD:
Over the years, the SEC has been pursuing the idea that it is inherently unfair when one party to a securities trade has more information than another. The prime example of this is Regulation FD, initially proposed under the chairmanship of Arthur Levitt in 2000, which attempted to ensure that companies do not provide material information to analysts unless that information is made public at the same time.
Wallison contrasts the SEC's position to that of Justice Powell, explaining that:
... there is also an important idea implicit in the Court’s statement that “it is the nature of this type of information” that it “cannot be made simultaneously available to all the corporation’s stockholders or the public generally.” The Court’s point was that the information would have no value to the analyst, and hence would not be collected, if it had to be made public before it could be used. In other words, the Court recognized that incentives are necessary to ensure that information gets into the market. In effect, the Supreme Court in 1983 was drawing a fine line between two competing values. On one side was the notion that corporate insiders should be punished for violating their fiduciary obligations to the company or its shareholders by disclosing inside information improperly. But on the other side was a desire to ensure--through appropriate incentives--that important information gets into the market and affects the market price of shares for the benefit of all investors.
The SEC’s approach is quite different. ... [The] agency focuses on the inequality of information between the informed and the uninformed traders at the moment of the trade. This approach naturally devalues incentives to supply information to the market, and in the end prefers a market in which both sides of a trade are equally ignorant rather than a market in which one trader profits at the expense of another.
It is precisely this set of concerns that is implicated by the so-called Galleon insider trading case. It may be that Raj Rajaratnam got information via tips from people who thereby breached a fiduciary duty they owed to the source of the information. But did Rajaratnam know they were doing so? Can the SEC prove not just that Rajaratnam had better access to information than the market generally, but that he got that information by being a participant after the fact in the tipper's breach of fiduciary duty?
There is a very serious risk that this case could chill aggressive but legitimate research by hedge funds and other professional investors. If so, the SEC will have done a serious disservice to the ordinary investors it claims to be protecting. Those investors will be left with a less efficient and less liquid market.
These concerns are particularly pronounced because, as the WSJ reported, this is not a one off case:
The investigation comes as the SEC has been increasing its focus on hedge funds and has ramped up surveillance to look for patterns and trends in trading. Over two years ago, the SEC expanded its focus beyond looking solely at individual stocks that had suspicious trading patterns. The agency put in place a new computer system that looks for traders who pop up repeatedly in insider-trading referrals, people familiar with the matter said.
All of which raises an age-old question: Quis custodiet ipsos custodes?
