John Carney explains that Manhattan US Attorney Preet Bharara has come up with a new rationale for justifying his huge insider trading prosecution:
... the new theory that is being marshaled against insider trading seems to be based on the idea that the pursuit of non-public information is resulting in an inefficient informational arms race. That’s the strongest case against the use of performance enhancing drugs in sports—that it creates an “arms race” atmosphere where players who wouldn’t otherwise use drugs feel pressured to begin using them to keep up with the enhanced players. In the end, if everyone ends up using performance enhancing drugs, no one winds up with an “unfair” advantage but lots of time and resources are wasted on the drugs.
In hedge fund investing, the analogy could be the use of these outside consultants that allegedly provide hedge funds with non-public information. Each fund manager has an incentive to seek the non-public information to gain a trading edge. But if everyone uses them, there’s no real advantage to their use. The time and resources spent acquiring the non-public information is simply wasted.
Bharara’s campaign against insider trading may be an attempt to end the informational arms race. That won’t make the playing field level—but it will make it so that naturally skilled traders are able to trade without inefficiently expending money to seek out non-public information. Which sort of makes you wonder if some of the top hedge fund managers—say, SAC Capital’s Steve Cohen—aren’t quietly cheering on the latest enforcement actions.
It's an interesting theory, which seems consistent with the facts. Look at who Bharara is targeting:
According to the Wall Street Journal, one of the Feds' targets in this probe is not a new one: so-called expert networks, which provide research "services" to hedge funds and mutual funds. Such services can include data and analysis, but very often consist merely of connecting a hedge fund analyst with an "expert" who might be a customer, client, or even employee of a company that the fund is an investor in. The networks reportedly being investigated are ones that most of us have never heard of: Primary Global Research and Broadband Research, both outfits that provide customers with intelligence about the technology industry.
To be sure, abuses of such networks might occur. BUT those networks also play a critical role in making markets more efficient. They help professional investors (the ones whose trading activities set prices) do a better job of valuing securities, which makes the market more efficient.
Because the defintion of insider trading is so vague, there is a risk that aggressive pursuit of these expert networks will chill legitimate activity. Justice Lewis Powell was well aware of this risk. In his seminal insider trading opinion Dirks v. SEC, he wrote that:
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. [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).
From everything I've seen so far, this prosecution treads perilously close to the same sort of chilling effect about which Justice Powell was concerned in Dirks. Indeed, this case is worse in that it involves criminal charges, while Dirks was a mere civil censure penalty.
I wonder if USA Bharara's ever read Dirks and, if so, whether he understood it. My guess is "no."
