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).]
[FN198]. Id.
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?
