The guilty plea hearing last week in the Justice Department’s prosecution of SAC Capital Advisors raised an interesting question about the law of insider trading: Just who are the victims of a violation? A provision of the federal securities laws gives those who traded at the same time as the insider a right to sue for a violation, but the Justice Department said they are not victims of the crime. ...
Instead, the focus in insider trading prosecutions is on protection of the markets, and the broader economy, as the true victim of the violation. In sentencing Raj Rajaratnam to 11 years in prison after his conviction, Federal District Court Judge Richard J. Holwell said that “insider trading is an assault on the free markets” and the “crimes reflect a virus in our business culture that needs to be eradicated.”
Yet the federal securities law sends a different message by authorizing those who traded at the time of the insider transactions to pursue a private lawsuit. The case filed by the Elan and Wyeth investors against SAC is under a little used provision,Section 20A of the Securities Exchange Act of 1934, that gives “contemporaneous traders” a right to sue those trading on inside information. ...
That creates an odd situation because investors on the opposite side of the transactions are provided a right to enforce the law but are not considered victims of the crime for purposes of whether to accept a plea agreement involving the same trades.
Insider trading is more about the unfairness of someone realizing benefits from unauthorized trading on confidential information than about identifying victims of the violation.
Sorry, but much of that analysis is wrong. To be sure, Henning is correct that individual investors are not the "victims" of insider trading. As I explain in Insider Trading: An Overview. Available at SSRN: http://ssrn.com/abstract=132529:
Insider trading is said to harm the investor in two principal ways. Some contend that the investor’s trades are made at the “wrong price.” A more sophisticated theory posits that the investor is induced to make a bad purchase or sale. Neither argument proves convincing on close examination.
An investor who trades in a security contemporaneously with insiders having access to material nonpublic information likely will allege injury in that he sold at the wrong price; i.e., a price that does not reflect the undisclosed information. If a firm’s stock currently sells at $10 per share, but after disclosure of the new information will sell at $15, a shareholder who sells at the current price thus will claim a $5 loss. The investor’s claim, however, is fundamentally flawed. It is purely fortuitous that an insider was on the other side of the transaction. The gain corresponding to shareholder’s “loss” is reaped not just by inside traders, but by all contemporaneous purchasers whether they had access to the undisclosed information or not. Bainbridge (1986, p.59).
To be sure, the investor might not have sold if he had had the same information as the insider, but even so the rules governing insider trading are not the source of his problem. The information asymmetry between insiders and public investors arises out of the federal securities laws’ mandatory disclosure rules, which allow firms to keep some information confidential even if it is material to investor decisionmaking. Unless immediate disclosure of material information is to be required, a step the law has been unwilling to take, there will always be winners and losers in this situation. Irrespective of whether insiders are permitted to inside trade or not, the investor will not have the same access to information as the insider. It makes little sense to claim that the shareholder is injured when his shares are bought by an insider, but not when they are bought by an outsider without access to information. To the extent the selling shareholder is injured, his injury thus is correctly attributed to the rules allowing corporate nondisclosure of material information, not to insider trading.
A more sophisticated argument is that the price effects of insider trading induce shareholders to make poorly advised transactions. In light of the evidence and theory recounted above in Section 6, however, it is doubtful whether insider trading produces the sort of price effects necessary to induce shareholders to trade. While derivatively informed trading can affect price, it functions slowly and sporadically. Gilson and Kraakman (1984, p.631). Given the inefficiency of derivatively informed trading, price or volume changes resulting from insider trading will only rarely be of sufficient magnitude to induce investors to trade.
Assuming for the sake of argument that insider trading produces noticeable price effects, however, and further assuming that some investors are misled by [785] those effects, the inducement argument is further flawed because many transactions would have taken place regardless of the price changes resulting from insider trading. Investors who would have traded irrespective of the presence of insiders in the market benefit from insider trading because they transacted at a price closer to the “correct” price; i.e., the price that would prevail if the information were disclosed. Dooley (1980, p.35-36); Manne (1966b, p.114). In any case, it is hard to tell how the inducement argument plays out when investors are examined as a class. For any given number who decide to sell because of a price rise, for example, another group of investors may decide to defer a planned sale in anticipation of further increases.
But the idea that a prohibition of insider trading is necessary to protect the markets is simply not true, as I explain in that article:
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.
Likewise, insider trading is simply not unfair. Granted, there seems to be a widely shared view that there is something inherently sleazy about insider trading. As a California state court put it, insider trading is “a manifestation of undue greed among the already well-to-do, worthy of legislative intervention if for no other reason than to send a message of censure on behalf of the American people.”
Given the draconian penalties associated with insider trading, however, vague and poorly articulated notions of fairness surely provide an insufficient justification for the prohibition. Can we identify a standard of reference by which to demonstrate that insider trading ought to be prohibited on fairness grounds? In my judgment, we cannot.
Fairness can be defined in various ways. Most of these definitions, however, collapse into the various efficiency-based rationales for prohibiting insider trading. We might define fairness as fidelity, for example, by which I mean the notion that an agent should not cheat her principal. But this argument only has traction if insider trading is in fact a form of cheating, which in turn depends on how we assign the property right to confidential corporate information. Alternatively, we might define fairness as equality of access to information, but this definition must be rejected in light of Chiarella’s rejection of the Texas Gulf Sulphur equal access standard. Finally, we might define fairness as a prohibition of injuring another. But such a definition justifies an insider trading prohibition only if insider trading injures investors, which seems unlikely for the reasons discussed in the next section. Accordingly, fairness concerns need not detain us further; instead, we can turn directly to the economic arguments against insider trading.
Instead, insider trading is a problem only to the extent that it involves theft of information:
There are essentially two ways of creating property rights in information: allow the owner to enter into transactions without disclosing the information or prohibit others from using the information. In effect, the federal insider trading prohibition vests a prop-erty right of the latter type in the party to whom the insider trader owes a fiduciary duty to refrain from self-dealing in confidential information. To be sure, at first blush, the in-sider trading prohibition admittedly does not look very much like most property rights. Enforcement of the insider trading prohibition admittedly differs rather dramatically from enforcement of, say, trespassing laws. The existence of property rights in a variety of in-tangibles, including information, however, is well-established. Trademarks, copyrights, and patents are but a few of the better known examples of this phenomenon. There are striking doctrinal parallels, moreover, between insider trading and these other types of property rights in information. Using another’s trade secret, for example, is actionable only if taking the trade secret involved a breach of fiduciary duty, misrepresentation, or theft. As Dooley (1995, p.776) observes, this is an apt summary of the law of insider trad-ing after the Supreme Court’s decisions in Chiarella and Dirks.
In context, moreover, even the insider trading prohibition’s enforcement mechanisms are not inconsistent with a property rights analysis. Where public policy argues for giving someone a property right, but the costs of enforcing such a right would be excessive, the state often uses its regulatory powers as a substitute for creating private property rights. Insider trading poses just such a situation. Private enforcement of the insider trading laws is rare and usually parasitic on public enforcement proceedings. Dooley (1980, p.15-17) . Indeed, the very nature of insider trading arguably makes public regulation essential pre-cisely because private enforcement is almost impossible. Bainbridge (1993, p.29) . The insider trading prohibition’s regulatory nature thus need not preclude a property rights-based analysis.
The rationale for prohibiting insider trading is precisely the same as that for prohibit-ing patent infringement or theft of trade secrets: protecting the economic incentive to produce socially valuable information. (An alternative approach is to ask whether the par-ties, if they had bargained over the issue, would have assigned the property right to the corporation or the inside trader. For a hypothetical bargain-based argument that the prop-erty right would be assigned to the corporation in the lawyer—corporate client context, see Bainbridge (1993, p. 27-34) .)
As the theory goes, the readily appropriable nature of information makes it difficult for the developer of a new idea to recoup the sunk costs incurred to develop it. If an in-ventor develops a better mousetrap, for example, he cannot profit on that invention with-out selling mousetraps and thereby making the new design available to potential competitors. Assuming both the inventor and his competitors incur roughly equivalent marginal costs to produce and market the trap, the competitors will be able to set a mar-ket price at which the inventor likely will be unable to earn a return on his sunk costs. Ex post, the rational inventor should ignore his sunk costs and go on producing the improved mousetrap. Ex ante, however, the inventor will anticipate that he will be unable to gener-ate positive returns on his up-front costs and therefore will be deterred from [793] devel-oping socially valuable information. Accordingly, society provides incentives for inventive activity by using the patent system to give inventors a property right in new ideas. By preventing competitors from appropriating the idea, the patent allows the inven-tor to charge monopolistic prices for the improved mousetrap, thereby recouping his sunk costs. Trademark, copyright, and trade secret law all are justified on similar grounds.
This argument does not provide as compelling a justification for the insider trading prohibition as it does for the patent system. A property right in information should be created when necessary to prevent conduct by which someone other than the developer of socially valuable information appropriates its value before the developer can recoup his sunk costs. Insider trading, however, often does not affect an idea’s value to the corpora-tion and probably never entirely eliminates its value. Legalizing insider trading thus would have a much smaller impact on the corporation’s incentive to develop new infor-mation than would, say, legalizing patent infringement.
The property rights approach nevertheless has considerable justificatory power. Con-sider the prototypical insider trading transaction, in which an insider trades in his em-ployer’s stock on the basis of information learned solely because of his position with the firm. There is no avoiding the necessity of assigning the property right to either the cor-poration or the inside trader. A rule allowing insider trading assigns the property right to the insider, while a rule prohibiting insider trading assigns it to the corporation.
From the corporation’s perspective, we have seen that legalizing insider trading would have a relatively small effect on the firm’s incentives to develop new information. In some cases, however, insider trading will harm the corporation’s interests and thus adversely affect its incentives in this regard. This argues for assigning the property right to the corporation, rather than the insider.
Those who rely on a property rights-based justification for regulating insider trading also observe that creation of a property right with respect to a particular asset typically is not dependent upon there being a measurable loss of value resulting from the asset’s use by someone else. Indeed, creation of a property right is appropriate even if any loss in value is entirely subjective, both because subjective valuations are difficult to measure for purposes of awarding damages and because the possible loss of subjective values pre-sumably would affect the corporation’s incentives to cause its agents to develop new in-formation. As with other property rights, the law therefore should simply assume (although the assumption will sometimes be wrong) that assigning the property right to agent-produced information to the firm maximizes the social incentives for the produc-tion of valuable new information.
[794] Because the relative rarity of cases in which harm occurs to the corporation weakens the argument for assigning it the property right, however, the critical issue may be whether one can justify assigning the property right to the insider. On close examina-tion, the argument for assigning the property right to the insider is considerably weaker than the argument for assigning it to the corporation. As we have seen, some have argued that legalized insider trading would be an appropriate compensation scheme. In other words, society might allow insiders to inside trade in order to give them greater incen-tives to develop new information. As we have also seen, however, this argument appears to founder on grounds that insider trading is an inefficient compensation scheme. Even assuming that the change in stock price that results once the information is released accu-rately measures the value of the innovation, the insider’s trading profits are not correlated to the value of the information. This is so because his trading profits are limited not by the value of the information, but by the amount of shares the insider can purchase, which in turn depends mainly upon his ex ante wealth or access to credit.
A second objection to the compensation argument is the difficulty of restricting trad-ing to those who produced the information. The costs of producing information normally are much greater than the costs of distributing it. Thus, many firm employees may trade on the information without having contributed to its production.
The third objection to insider trading as compensation is based on its contingent na-ture. If insider trading were legalized, the corporation would treat the right to inside trade as part of the manager’s compensation package. Because the manager’s trading returns cannot be measured ex ante, however, the corporation cannot ensure that the manager’s compensation is commensurate with the value of her services.
The economic theory of property rights in information thus cannot justify assigning the property right to insiders rather than to the corporation. Because there is no avoiding the necessity of assigning the property right to the information in question to one of the relevant parties, the argument for assigning it to the corporation therefore should prevail.
The argument in favor of assigning the property right to the corporation becomes even stronger when we move outside the prototypical situation to cases covered by the misappropriation theory. It is hard to imagine a plausible justification for assigning the property right to those who steal information.
