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Insider Trading Under Sarbanes-Oxley § 807 and 18 USC § 1348

In my article, Regulating Insider Trading in the Post-Fiduciary Duty Era: Equal Access or Property Rights, in Research Handbook on Insider Trading 80 (Edward Elgar Publishing; Stephen M. Bainbridge ed. 2013), I argued that:

In Chiarella and Dirks, the Supreme Court based insider trading liability on a breach of a disclosure obligations arising out of a fiduciary relationship. The resulting narrowing of the scope of insider trading liability met substantial resistance from the Securities and Exchange Commission (SEC) and the lower courts. Through both regulatory actions and judicial opinions, the SEC and the courts gradually chipped away at the fiduciary duty rationale. In recent years, the trend has accelerated, with several developments having substantially eviscerated the fiduciary duty requirement.

The current unsettled state of insider trading jurisprudence necessitates rethinking the foundational premises of that jurisprudence from first principles. This essay argues that the correct rationale for regulation insider trading is protecting property rights in information. Although that rationale obviously has little to do with the traditional concerns of securities regulation, this article further argues that the SEC has a sufficiently substantial advantage in detecting and prosecuting insider trading that it should retain jurisdiction over the offense.

In the course of that article, I discussed insider trading Under Sarbanes-Oxley § 807 and 18 USC § 1348:

Section 807 of the Sarbanes-Oxley Act added a new § 1348 to the US Criminal Code, which provides that:

Whoever knowingly executes, or attempts to execute, a scheme or artifice—

(1) to defraud any person in connection with any security of an issuer with a class of securities registered under section 12 of the Securities Exchange Act of 1934 or that is required to file reports under section 15(d) of the Securities Exchange Act of 1934; or

(2) to obtain, by means of false or fraudulent pretenses, representations, or promises, any money or property in connection with the purchase or sale of any security of an issuer with a class of securities registered under section 12 of the Securities Exchange Act of 1934  or that is required to file reports under section 15(d) of the Securities Exchange Act of 1934

shall be fined under this title, or imprisoned not more than 25 years, or both.[1]

Neither the text nor its sparse legislative history shed much light on what Congress intended it to do. About all one can say for sure is that Congress intended to significantly increase the penalties in securities fraud cases and to make it easier for prosecutors to prove such cases by eliminating the so-called “technical elements” of existing provisions such as § 10(b) and Rule 10b-5.[2] Is Powell’s fiduciary duty requirement such a technical element?

In US v. Mahaffy,[3] defendant stockbrokers tipped nonpublic information to defendant day traders in return for cash. The case could and should have been prosecuted under the misappropriation theory.  In Mahaffy, however, the prosecutors charged the defendants with violating § 1348. In upholding the charge as a proper one, the district court did not require the prosecution to prove that the tippers had breached a duty of confidence arising out of a fiduciary relationship owed either to the source of the relationship or to the persons with whom the tippees traded. Indeed, of the Supreme Court trilogy, the district court mentioned only O’Hagan and only in passing.[4]

“The Mahaffy decision [thus] reflects the first step of a potential sea change in the elements required of the government to prove a criminal insider trading violation.”[5] It casts aside, albeit sub silentio, the need for the prosecution to show a breach of a duty to disclose arising out of a fiduciary relationship or similar relationship of trust and confidence. Instead, by analogizing “§ 1348 to an honest services fraud case,” Mahaffy “requires only a material misrepresentation, not a violation of confidence.”[6] Although the SEC will be unable to avail itself of § 1348 potentially significant gutting of the fiduciary duty requirement, since the SEC lacks power to bring criminal cases, § 1348 thus must nevertheless be counted as having knocked one more brick out of the wall.

Now Karen Woody has posted an article length treatment of Section 807:

Since Sarbanes-Oxley, there has been a sleepy provision of the criminal code that could present an end-around to the morass of insider trading precedents under Rule 10b-5. Under 18 U.S.C. §1348, the government can bring an insider trading case under the more general umbrella of securities fraud, which has scant jurisprudential precedent. In other words, the heavily-litigated personal benefit test found in Dirks may not apply to a charge of insider trading under §1348. The elements required to prove a charge under §1348 are similar to other fraud-based offenses such as mail and wire fraud, health care fraud, and bank fraud. Whether §1348 was intended to apply to insider trading in particular is an open question, and a broader question is whether the jurisprudential interpretation for the elements of the crime of insider trading as defined under Rule 10b-5 should be imported into the judicial interpretation of § 1348. In other words, if the conduct that constitutes criminal insider trading under Rule 10b-5 exists only if the elements of the Dirks test are met, then a §1348 charge for criminal insider trading may create an entirely new scheme and definition of the crime. This Article analyzes the potential of this dual paradigm, and argues that, given the uncertainty and shifting parameters of insider trading prohibitions, application of §1348 to insider trading should be afforded the rule of lenity.

Woody, Karen E., The New Insider Trading (October 1, 2019). Arizona State Law Journal, Forthcoming; Washington & Lee Legal Studies Paper No. 2019-22. Available at SSRN: https://ssrn.com/abstract=3474570 or http://dx.doi.org/10.2139/ssrn.3474570

Recommended reading.

Do female insiders trade differently than male insiders?

Eckbo, B. Espen and Ødegaard, Bernt Arne, Insider Trading and Gender (October 24, 2019). Tuck School of Business Working Paper No. 3475061. Available at SSRN: https://ssrn.com/abstract=3475061 or http://dx.doi.org/10.2139/ssrn.3475061

We provide comprehensive, gender-based estimates of the performance of primary insiders' non-routine trades on the Oslo Stock Exchange. Regardless of gender, the time-series of insider holdings fail to indicate that insiders "buy low and sell high". However, there is evidence that the dramatic increase in the network of female directors following Norway's 2005 board gender-balancing law has increased the market reaction to female insider purchases. Moreover, female insider purchases spike following the market crash in 2008, both absolutely and relative to male insiders, which contradicts the conventional view that females are more risk averse than males.

Huh.

Yours truly cited re validity of disgorgement as relief in cases brought by the SEC

In SEC v. Westport Capital Markets LLC., 2019 WL 4857337 (D. Conn. Sept. 30, 2019), THE SEC "accused Westport Capital Markets, LLC, and its owner Christopher E. McClure of violating the Investment Advisers Act of 1940. Westport and McClure have moved to dismiss the SEC complaint to the extent that it seeks a disgorgement remedy."

The Court declined to decide the motion at present, explaining that:

Deferring decision on whether the Court may enter a disgorgement remedy is appropriate in view of uncertainty about the ... extent the SEC may seek disgorgement for strictly victim restitutionary purposes and whether disgorgement for victim restitutionary purposes may retain an equitable character that distinguishes it from disgorgement for deterrent penalty purposes. 

A further reason to forbear ruling for now on the defendants' motion is the likelihood that precedent on whether the SEC may continue to seek a disgorgement remedy may change or be clarified in the coming months. ...

Now pending before the U.S Supreme Court is a certiorari petition on the issue of “[w]hether the Securities and Exchange Commission may seek and obtain disgorgement from a court as ‘equitable relief’ for a securities law violation even though this Court has determined that such disgorgement is a penalty.” Liu v. SEC, No. 18-1501 (petition for writ of certiorari filed on May 31, 2019); see also Stephen Bainbridge, Kokesh Footnote 3 Notwithstanding: The Future of the Disgorgement Penalty in SEC Cases, 56 WASH. U. J. L. & POL'Y 17 (2018); Daniel B. Listwa & Charles Seidell, Note, Penalties in Equity: Disgorgement After Kokesh v. SEC, 35 Yale J. Reg. 667 (2018).

Granted, it's not much of a cite. But it counts. Now I need to get the Supreme Court to cite the article.

On that score, I was pleased to see that counsel for petitioners in the Liu case cited my article in their brief:

The SEC first successfully obtained disgorgement in SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77 (S.D.N.Y. 1970), aff’d in part, rev’d and remanded in part on other grounds, 446 F.2d 1301 (2d Cir. 1971). See Stephen M. Bainbridge, Kokesh Footnote Three Notwithstanding: The Future of the Disgorgement Penalty in SEC Cases, 56 Wash. U. J.L. & Pol’y 17, 20- 21 (2018). The Second Circuit affirmed the award, adding that “the SEC may seek other than injunctive relief in order to effectuate the purposes of the Act.” SEC v. Texas Gulf Sulphur Co., 446 F.2d 1301, 1308 (2d Cir. 1971). Even there, however, the court noted that such equitable relief must be “remedial” and thus cannot be “a penalty assessment.” Id.

It'd have been nice if they had cited the arguments I made on the merits, but so be it.

Yours truly cited by Virginia Federal District Court re Whether Disgorgement is a Penalty

U.S. v. Bank, 2:17CR126, 2019 WL 2023734, at *4 (E.D. Va. May 8, 2019)

Kokesh has sparked a debate about whether district courts have the authority at all to impose disgorgement because the Supreme Court appeared to question such authority. See Kokesh, 137 S. Ct. at 1642 n.3 (stating that the court offered “[n]o opinion on whether courts possess authority to order disgorgement in SEC proceedings”); Donna M. Nagy, The Statutory Authority for Court-Ordered Disgorgement in SEC Enforcement Actions, 71 S.M.U. L. Rev. 896, 898 (2018) (explaining how, at oral argument for Kokesh, the Justices questioned the authority to order disgorgement and invited challenges to it by disclaiming, in a footnote of the opinion, that it was not deciding the issue). Those arguing there is no authority for disgorgement suggest that, now that disgorgement has been declared a penalty, it can no longer be within a district court's equitable authority because a court cannot impose penalties when acting in equity. See, e.g., Stephen M. Bainbridge, INSIDER TRADING: Kokesh Footnote Three Notwithstanding: The Future of the Disgorgement Penalty in SEC Cases, 56 Wash. U. J.L. & Pol'y 17, 21-22 (2018). Those arguing that there is authority posit that just because disgorgement is a penalty for one purpose does not mean it is a penalty for all purposes, and that Congress has expressly recognized a court's power to order disgorgement. See, e.g., Nagy, supra, at 901-903. In March of 2019, a bill was introduced in the Senate that would resolve this debate by amending 15 U.S.C. § 78u(d) to expressly grant district courts the authority to order disgorgement. Securities Fraud Enforcement and Investor Compensation Act of 2019, S.799, 116th Cong. (2019).

That said, a district court's authority to order disgorgement is not at issue here. Accordingly, the Court assumes, for the purposes of this motion only, that district courts necessarily have the authority to order disgorgement under the equitable authority granted to them by one of the statutes discussed above. See 15 U.S.C. §§ 77t(b), 77v(a), 78aa, 78u(d) (1).

The cited article is: Bainbridge, Stephen Mark, Kokesh Footnote 3 Notwithstanding: The Future of the Disgorgement Penalty in SEC Cases. 56 Washington University Journal of Law & Policy 17 (2018); UCLA School of Law, Law-Econ Research Paper No. 17-12. Available at SSRN: https://ssrn.com/abstract=2992719

Jeff Skilling released after 12 years in jail

NY Times covers it here. Prior coverage from my blog:

Rethinking Jeff Skilling's conviction

After the financial crisis and the recent insider trading convictions of Raj Rajaratnam and Rajat Gupta, perhaps it is time to reconsider the plight of Jeffrey K. Skilling.... The problem is that the case against the Enron executive was...

Predicting Enron

Back in January, Gordon Smith said he "would not be surprised to see both Ken Lay and Jeff Skilling acquitted, but perhaps the government's case is stronger than I expect." Now Gordon says: "The government's case was pretty much what...

Lea Fastow's Withdrawn Plea

Regular readers will recall that we have been folllowing the misadventures of Andrew Fastow, former CFO at Enron, and his wife Lea. Andrew had agreed to coperate with the feds investigating Jeff Skilling and Ken Lay, provided his wife go...

SOX Whistleblower Provisions

Part of the Enron mythology is that former Enron VP Sherron Watkins blew the whistle on Ken Lay, Jeff Skilling, and their fellow miscreants. In fact, however, so-called “Enron whistle-blower” Sherron Watkins never really blew a whistle. ...

After the financial crisis and the recent insider trading convictions of Raj Rajaratnam and Rajat Gupta, perhaps it is time to reconsider the plight of Jeffrey K. Skilling.... The problem is that the case against the Enron executive was...

Back in January, Gordon Smith said he "would not be surprised to see both Ken Lay and Jeff Skilling acquitted, but perhaps the government's case is stronger than I expect." Now Gordon says: "The government's case was pretty much what...

Regular readers will recall that we have been folllowing the misadventures of Andrew Fastow, former CFO at Enron, and his wife Lea. Andrew had agreed to coperate with the feds investigating Jeff Skilling and Ken Lay, provided his wife go...

Part of the Enron mythology is that former Enron VP Sherron Watkins blew the whistle on Ken Lay, Jeff Skilling, and their fellow miscreants. In fact, however, so-called “Enron whistle-blower” Sherron Watkins never really blew a whistle. ...

Rethinking Jeff Skilling's conviction

After the financial crisis and the recent insider trading convictions of Raj Rajaratnam and Rajat Gupta, perhaps it is time to reconsider the plight of Jeffrey K. Skilling.... The problem is that the case against the Enron executive was...

Back in January, Gordon Smith said he "would not be surprised to see both Ken Lay and Jeff Skilling acquitted, but perhaps the government's case is stronger than I expect." Now Gordon says: "The government's case was pretty much what...

Regular readers will recall that we have been folllowing the misadventures of Andrew Fastow, former CFO at Enron, and his wife Lea. Andrew had agreed to coperate with the feds investigating Jeff Skilling and Ken Lay, provided his wife go...

Part of the Enron mythology is that former Enron VP Sherron Watkins blew the whistle on Ken Lay, Jeff Skilling, and their fellow miscreants. In fact, however, so-called “Enron whistle-blower” Sherron Watkins never really blew a whistle. ...

Another new book chapter by yours truly: "The Law and Economics of Insider Trading 2.0"

Bainbridge, Stephen Mark, The Law and Economics of Insider Trading 2.0. Forthcoming in Encyclopedia of Law and Economics (2nd edition 2020); UCLA School of Law, Law-Econ Research Paper No. 19-01. Available at SSRN: https://ssrn.com/abstract=3312406:

Insider trading is one of the most controversial aspects of securities regulation, even among the law and economics community. One set of scholars favors deregulation of insider trading, allowing corporations to set their own insider trading policies by contract. Another set of law and economics scholars, in contrast, contends that the property right to inside information should be assigned to the corporation and not subject to contractual reassignment. Deregulatory arguments are typically premised on the claims that insider trading promotes market efficiency or that assigning the property right to inside information to managers is an efficient compensation scheme. Public choice analysis is also a staple of the deregulatory literature, arguing that the insider trading prohibition benefits market professionals and managers rather than investors. The argument in favor of regulating insider trading traditionally was based on fairness issues, which predictably have had little traction in the law and economics community. Instead, the economic argument in favor of mandatory insider trading prohibitions has typically rested on some variant of the economics of property rights in information. This is a chapter from the forthcoming Encyclopedia of Law and Economics (2nd edition 2020).

Keywords: Insider trading

JEL Classification: K22, G30, G38

New book chapter by yours truly: "Insider Trading Compliance Programs"

Bainbridge, Stephen Mark, Insider Trading Compliance Programs (January 8, 2019). UCLA School of Law, Law-Econ Research Paper No. 19-02. Available at SSRN: https://ssrn.com/abstract=3312430:

This chapter in a forthcoming handbook on corporate compliance provides an overview of corporate insider trading compliance programs. It sets out the basic legal framework of the federal insider trading prohibition. It then reviews the reasons corporations adopt compliance programs. The chapter next reviews the basic elements of an insider trading compliance program. Finally, the chapter examines the special case of Rule 10b5-1 compliance programs.

Keywords: insider trading, compliance

JEL Classification: K22

Andrew Verstein on Insider Trading in Securities of Insolvent Firms

Andrew Verstein is doing some of the most interesting work among junior corporate law scholars. His latest piece on insider trading in securities of insolvent firms is a great example. He's got a summary of his new article available here, which I highly recommend.

Park on "Insider Trading and the Integrity of Mandatory Disclosure"

My friend and UCLAW colleague Jim Park has just posted a new article:

Insider trading regulation has been primarily shaped by two theories. The first argues that unequal access to material information corrupts the integrity of securities markets. The second contends that insider trading primarily undermines the property rights of a corporation. The dominance of the market integrity and property frameworks has obscured an important reason to regulate insider trading – it can undermine the integrity of the disclosure mandated by the securities laws. Such disclosure is meant to benefit all investors and should not be exploited by a few. Insider trading is particularly problematic in a periodic disclosure system where the release of significant information is deliberately delayed so it can be analyzed and verified. This Article argues that protecting the integrity of mandatory disclosure is a compelling reason for insider trading regulation. This disclosure approach suggests clearer limits to the reach of insider trading law and enforcement than the market integrity and property theories.

Park, James J., Insider Trading and the Integrity of Mandatory Disclosure (October 1, 2018). 2018 Wisconsin Law Review (Forthcoming); UCLA School of Law, Law-Econ Research Paper No. 18-12. Available at SSRN: https://ssrn.com/abstract=3258608

Verstein on Insider Trading in the Stocks of Insolvent Corporations

Andrew Verstein writes:

Are insolvent firms different from solvent firms with respect to insider trading law and policy? Formally, the law does not change. But economic realities and non-securities law duties do. As a result, the insider trading landscape changes considerably. The law is more permissive in some ways, and more constraining in others, as troubled instruments trade.

It's a very interesting analysis. And one that I have not thought about before. (Verstein's very good at sniffing out these sort of seemingly obscure problems that turn out to be interesting and important.)

I'm going to have to mull this one over for a while.

Heartland Payment Systems sues ex-CEOs girlfriend for trading on inside information (sort of)

Back in June Reuters reported that:

The U.S. Securities and Exchange Commission on Tuesday charged the former chief executive of Heartland Payment Systems Inc and his romantic partner with insider trading ahead of the payment processor's $4.3 billion takeover by Global Payments Inc .

Robert Carr, Heartland's founder and CEO, was accused of telling Katherine Hanratty in November 2015 that Global Payments had offered to buy Princeton, New Jersey-based Heartland for a premium and giving her a $1 million check with instructions to open a brokerage account and buy $900,000 of Heartland stock.

Hanratty did what Carr asked, and sold her stock for a $250,628 profit in April 2016, four months after the merger was announced, the SEC said in a complaint filed with the federal court in New Haven, Connecticut.

Apparently Hanratty was not acting as a straw man for Carr, but rather was the beneficiary of a tip (quid pro quo in return for sexual favors or maybe just a gift) from Carr, as the SEC complaint alleges:

On November 23, 2015, Hanratty emailed Carr to express her gratitude and stated “for the first time ever I feel a sense of relief knowing that I have some security.” Referring to the $1 million, Hanratty repeated that “I have done exactly what you recommended I do with it and made you the beneficiary of the account.” Carr replied via email that he was glad that she was not so stressed anymore.

So far all of this seems pretty run of the mill. Slam dunk for the SEC is the phrase that comes to mind. And, indeed, Fox reported that Hanratty settled the SEC charges and paid disgorgement of her profits and a $250,000 fine.

But here's where it gets interesting. Bloomberg is now reporting that:

Heartland Payment Systems LLC is suing its former CEO’s girlfriend for making insider trades based on tips he passed on about an upcoming merger. ...

In fact,  Heartland is suing both Hanratty and Carr. Count I of the complaint alleges that Carr breached his Delaware corporate law fiduciary duty by disclosing the information to Hanratty. Count 2 alleges that Hanratty added and abetted Carr's breach in violation of state corporate law.

This is a very unusual suit. It's rare that an issuer sues an employee (even a former employee) for alleged insider trading. Not unheard of, but rare. As Richard Booth explains:

So why is it that issuers seldom seek disgorgement on their own? It is possible that the practice is common and quietly handled, but I doubt it. One obvious reason that issuers do not often sue their own for insider trading is an inherent conflict of interest. It is often the case that the culprits have the power to decide whether the corporation should sue. Still, that does not explain why there are few derivative actions in connection with insider trading. On the other hand, it appears that the number of derivative actions brought in tandem with securities fraud class actions has been increasing in recent years. Another somewhat less obvious reason for the disinclination of issuers to go after inside trading is that it might often amount to an admission that the company failed to disclose material information in a timely fashion and might trigger the filing of a securities fraud class action. Thus, as I have argued elsewhere, the disproportionate threat of securities fraud class actions and their potentially devastating collateral consequences may prevent publicly traded companies from self-policing.

Richard A. Booth, The Missing Link Between Insider Trading and Securities Fraud, 2 J. Bus. & Tech. L. 185, 206 n.104 (2007).

The fact that Heartland had had a change of ownership may be pertinent. The new owners may have had a beef with Carr.

So what will Hearland have to prove to win against Hanratty? “The elements of a claim for aiding and abetting a breach of a fiduciary duty are: (1) the existence of a fiduciary relationship, (2) the fiduciary breached its duty, (3) a defendant, who is not a fiduciary, knowingly participated in a breach, and (4) damages to the plaintiff resulted from the concerted action of the fiduciary and the non-fiduciary.” Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160, 172 (Del. 2002)

As for # 2, what Carr allegedly did was a breach of Delaware fiduciary duty law. Delaware courts have recognized a "a corporate claim for insider trading" based on the duty of loyalty. Pfeiffer v. Toll, 989 A.2d 683, 704 (Del. Ch. 2010), abrogated on other grounds by by Kahn v. Kolberg Kravis Roberts & Co., L.P., 23 A.3d 831 (Del. 2011):

The plaintiff must show that: “1) the corporate fiduciary possessed material, nonpublic company information; and 2) the corporate fiduciary used that information improperly by making trades because she was motivated, in whole or in part, by the substance of that information.”

Kahn v. Kolberg Kravis Roberts & Co., L.P., 23 A.3d 831, 838 (Del. 2011).

The Congressman Chris Collins insider trading indictment: Some interesting (at least to me) angles

CNBC reports:

Rep. Chris Collins, R-N.Y. pleaded not guilty Wednesday afternoon to federal insider trading charges, according to NBC News.

The congressman was arrested earlier in the day on charges that he shared non-public information with family and friends related to Australian biotech company Innate Immunotherapeutics, on which Collins served as a board member.

An indictment released Wednesday alleges that Collins, 68, scrambled to call his son from the White House lawn and share information with him about a failed drug trial, and that his son and others then sold stock based on that tip before the trial results became public.

Collins' son, Cameron Collins, 25, as well as the father of his fiancee, Stephen Zarsky, 66, were also charged, according to the court filing.

(1) This is not the long awaited enforcement action under The Stock Act (about which I have written often). Instead, it appears that Collins is the largest shareholder and a member of the board of directors of Innate. So it's just standard classical insider trading. (See my treatise on insider trading for more information.)

(2) House Of Representatives Rule 25, clause 2, states that a Member may not "serve for compensation as an officer or member of the board of an association, corporation, or other entity." Was Collins serving on an uncompensated basis?

(3) Do the House conflict of interest rules really allow a Member to serve on a committee with oversight jurisdiction over a company for whom s/he is the largest shareholder and/or a board member? if so, why? Seems like a huge conflict of interest.

(4) On what basis is the personal benefit requirement for imposing tipping liability satisfied with respect to Zarsky (I've also written often about that requirement)? In Salman v. US, the Supreme Court recently held that:

Section 10(b) of the Securities Exchange Act of 1934 and the Securities and Exchange Commission’s Rule 10b–5 prohibit undisclosed trading on inside corporate infor- mation by individuals who are under a duty of trust and confidence that prohibits them from secretly using such information for their personal advantage. ...

These persons also may not tip inside information to others for trading. The tippee acquires the tipper’s duty to disclose or abstain from trading if the tippee knows the information was disclosed in breach of the tipper’s duty, and the tippee may commit securities fraud by trading in disregard of that knowledge. In Dirks v. SEC, 463 U. S. 646 (1983), this Court explained that a tippee’s liability for trading on inside information hinges on whether the tip- per breached a fiduciary duty by disclosing the information. A tipper breaches such a fiduciary duty, we held, when the tipper discloses the inside information for a personal benefit. And, we went on to say, a jury can infer a personal benefit—and thus a breach of the tipper’s duty—where the tipper receives something of value in exchange for the tip or “makes a gift of confidential information to a trading relative or friend.” ...

Making a gift of inside information to a relative ... is little different from trading on the information, obtaining the profits, and doling them out to the trading relative. The tipper benefits either way.

So this picks up Collins' tip to his son. But Zarsky is not yet a relative. At most, he is a future potential relative by marriage. There is also the problem that Zarsky is (somewhat of) a remote tippee (ditto re having written about it), which is always problematic.

(5) Socialist (and nominal Democrat) Congressional candidate Alexandria Ocasio-Cortez claims she is being attacked by "the right" to distract people from the Collins indictment. Um, no. She's being attacked because she's a socialist and that's a bad thing to be.

(6) Did Collins et al. learn nothing from the Sam Waksal/Martha Stewart debacle? The SEC and the stock markets are very, very good at picking up major stock transactions by large shareholders, directors, and officers of companies that suffer bad news. As Josh Barro wrote:

Perhaps it is sometimes possible to trade on insider information and have those trades go unnoticed amid a sea of non-insider trades. But if the non-public information you’re trading on is likely to tank the stock price by more than 90%, and your trades are going to make up about 15 times the stock’s typical daily trading volume, and your close associate sits on the company’s board of directors, it is probably not best to assume that your trades will get lost in the shuffle.

I would thus agree with the CNN analyst who said  "It's the dumbest insider trading crime I've ever seen," except for the fact that the Waksal/Stewart case still strikes me as dumber.

 

Is Interference with Corporate Plans a Valid Reason for Regulating Insider Trading? (Not really.)

In an earlier post, I mentioned that James Cox has a new paper on the famous Texas Gulf Sulphur decision, in which he explores various rationales for regulating insider trading that can be discerned from the factual background of the opinion (as opposed to the legal analysis in the opinion, which I have demonstrated elsewhere is completely bogus, as the court hopelessly misrepresented the precedents on which it relied). One concerned delayed disclosure, which I discussed in a prior post. The other one he advances is potential interference with corporate plans:

The employee defendants in TGS did not reveal to Timmins landowners their secret knowledge of K-55-1. Nonetheless, their trading and tipping posed the same risks to TGS’s ability to exploit its discovery. It is reasonable to fear that trading, certainly as massive as was carried out by the TGS defendants, could have alerted markets and TGS competitors of on-going material, secret developments at the firm. If this surmise is plausible, then ... proscription of the agent’s threatening conduct would be a reasonable prophylaxis.

I agree that interference with corporate plans is a legitimate concern, as I explained in my insider trading text. But I don't think it is a particularly strong argument for a federal prohibition of insider trading under the securities laws.

Trading during the planning stage of an acquisition is a classic example of how insider trading might adversely interfere with corporate plans. If managers charged with overseeing an acquisition buy shares in the target, and their trading has a significant up-ward effect on the price of the target’s stock, the takeover will be more expensive. If their trading causes significant price and volume changes, that also might tip off others to the secret, interfering with the bidder’s plans, as by alerting the target to the need for defensive measures.

The risk of premature disclosure poses an even more serious threat to corporate plans. The issuer often has just as much interest in when information becomes public as it does in whether the information becomes public. Suppose Target, Inc., enters into merger negotiations with a potential acquirer. Target managers who inside trade on the basis of that information will rarely need to delay corporate action in order to effect their purchases. Having made their purchases, however, the managers now have an incentive to cause disclosure of Target’s plans as soon as possible. Absent leaks or other forms of derivatively informed trading, the merger will have no price effect until it is disclosed to the market, at which time there usually is a strong positive effect. Once the information is disclosed, the trading managers will be able to reap substantial profits, but until disclosure takes place, they bear a variety of firm-specific and market risks. The deal, the stock market, or both may collapse at any time. Early disclosure enables the managers to minimize those risks by selling out as soon as the price jumps in response to the announcement.

If disclosure is made too early, a variety of adverse consequences may result. If disclosure triggers competing bids, the initial bidder may withdraw from the bidding or demand protection in the form of costly lock-ups and other exclusivity provisions. Alternatively, if disclosure does not trigger competing bids, the initial bidder may conclude that it overbid and lower its offer accordingly. In addition, early disclosure brings the deal to the attention of regulators and plaintiffs’ lawyers earlier than necessary.

An even worse case scenario is suggested by SEC v. Texas Gulf Sulphur Co. Recall that insiders who knew of the ore discovery traded over an extended period of time. During that period the corporation was attempting to buy up the mineral rights to the affected land. If the news had leaked prematurely, the issuer at least would have had to pay much higher fees for the mineral rights, and may well have lost some land to competitors. Given the magnitude of the strike, which eventually resulted in a 300–plus percent increase in the firm’s market price, the harm that would have resulted from premature disclosure was immense.

Although insider trading probably only rarely causes the firm to lose opportunities, it may create incentives for management to alter firm plans in less drastic ways to increase the likelihood and magnitude of trading profits. For example, trading managers can accelerate receipt of revenue, change depreciation strategy, or alter dividend payments in an attempt to affect share prices and insider returns. Alternatively, the insiders might structure corporate transactions to increase the opportunity for secret keeping. Both types of decisions may adversely affect the firm and its shareholders. Moreover, this incentive may result in allocative inefficiency by encouraging overinvestment in those industries or activities that generate opportunities for insider trading.

Judge Frank Easterbrook has identified a related perverse incentive created by insider trading. Managers may elect to follow policies that increase fluctuations in the price of the firm’s stock. They may select riskier projects than the shareholders would prefer, because, if the risks pay off, they can capture a portion of the gains in insider trading and, if the project flops, the shareholders bear the loss. In contrast, Professors Carlton and Fischel assert that Easterbrook overstates the incentive to choose high-risk projects. Because managers must work in teams, the ability of one or a few managers to select high-risk projects is severely constrained through monitoring by colleagues. Cooperation by enough managers to pursue such projects to the firm’s detriment is unlikely because a lone whistle-blower is likely to gain more by exposing others than he will by colluding with them. Further, Carlton and Fischel argue managers have strong incentives to maximize the value of their services to the firm. Therefore, they are unlikely to risk lowering that value for short-term gain by adopting policies detrimental to long-term firm profitability. Finally, Carlton and Fischel alternatively argue that even if insider trading creates incentives for management to choose high-risk projects, these incentives are not necessarily harmful. Such incentives would act as a counterweight to the inherent risk aversion that otherwise encourages managers to select lower risk projects than shareholders would prefer. Allowing insider trading may encourage management to select negative net present value investments, however, not only because shareholders bear the full risk of failure, but also because failure presents management with an opportunity for profit through short-selling. As a result, shareholders might prefer other incentive schemes.

But what does all of this have to do with the policies underlying securities regulation? The risk that insiders may interfere with corporate plans to facilitate their trading is more a matter of state fiduciary duty law than federal securities law.

Is Delayed Disclosure a Valid Basis for Regulating Insider Trading? (No.)

James Cox has a new paper on the famous Texas Gulf Sulphur decision, in which he explores various rationales for regulating insider trading that can be discerned from the factual background of the opinion (as opposed to the legal analysis in the opinion, which I have demonstrated elsewhere is completely bogus, as the court hopelessly misrepresented the precedents on which it relied):

... in TGS, two of the major defendants traded in the interval between the misleading April twelfth press release and the corrective April sixteenth press release. To be sure, each had purchased TGS shares before the misleading press release, but essentially doubled-down after the release. Indeed, the second largest block of shares traded by any of the TGS insiders occurred in the interval between the misleading release and the corrective public release.

Against this record, we can premise an important justification for insider trading: by proscribing insider trading and tipping that yields a personal benefit to the insider, the law removes an incentive that insiders may have to delay the release of inside information. Stated differently, with investors benefitting from the early rather than later release of information, legal rules can better implement that objective by proscribing insiders who delay the release of information to enable them to exploit their secret knowledge of the information by trading on it.

I disagree, as I explained in my insider trading text:

To be sure, insider trading could injure the firm if it creates incentives for managers to delay the transmission of information to superiors. Decision making in any entity requires accurate, timely information. In large, hierarchical organizations, such as publicly traded corporations, information must pass through many levels before reaching senior managers. The more levels, the greater the probability of distortion or delay intrinsic to the system. This inefficiency can be reduced by downward delegation of decision-making authority but not eliminated. Even with only minimal delay in the upward transmission of information at every level, where the information must pass through many levels before reaching a decision-maker, the net delay may be substantial.

If a manager discovers or obtains information (either beneficial or detrimental to the firm), she may delay disclosure of that information to other managers so as to assure herself sufficient time to trade on the basis of that information before the corporation acts upon it. Even if the period of delay by any one manager is brief, the net delay produced by successive trading managers may be substantial. Unnecessary delay of this sort harms the firm in several ways. The firm must monitor the manager’s conduct to ensure timely carrying out of her duties. It becomes more likely that outsiders will become aware of the information through snooping or leaks. Some outsider may even independently discover and utilize the information before the corporation acts upon it.

Although delay is a plausible source of harm to the issuer, its importance is easily exaggerated. I am unaware of any evidence that delay is frequent or lengthy. Given the rapidity with which securities transactions can be conducted in modern secondary trading markets, a manager need at most delay corporate action long enough for a five minute telephone conversation with her stockbroker. Delay (either in transmitting information or taking action) also often will be readily detectable by the employer. Finally, and perhaps most importantly, insider trading may create incentives to release information early just as often as it creates incentives to delay transmission and disclosure of information.

In addition, to the extent (if any) that premature disclosure threatens the firm’s interests, that threat has little to do with the insider trading regime. Instead, it is properly treated as a breach of the insider’s fiduciary duty. 

Finally, concern for ensuring timely disclosure cannot justify a prohibition of the breadth it currently possesses. As we have seen, the prohibition encompasses a host of actors both within and outside the firm. In contrast, only a few actors are likely to have the power to affect the timing of disclosure. A much narrower prohibition thus would suffice if this were the principal rationale for regulating insider trading. Indeed, if this were the main concern, one need not prohibit insider trading at all. Instead, one could strike at the problem much more directly by proscribing failing to disclose material information in the absence of a legitimate corporate reason for doing so.

 

Langevoort on the surprisingly early demise of Texas Gulf Sulphur's equal access test

Fascinating new article by Don Langevoort:

The Second Circuit’s en banc decision in SEC v. Texas Gulf Sulphur Corp.[1] (“TGS”) is approaching its 50th anniversary, and it’s still well-known for several important holdings. Perhaps the most celebrated (or condemned) accepted the SEC’s argument that corporate insiders have a duty to “abstain or disclose” from trading while in possession of material nonpublic information.  The opinion makes a bold claim that the law in play (Rule 10b-5’s antifraud prohibition) “is based in policy on the justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information.”[2] From that comes a command of considerable breadth: “[A]nyone in possession of material inside information must either disclose it to the investing public, or, if he is disabled from disclosing it in order to protect a corporate confidence, or he chooses not to do so, must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed.”[3]

There is a standard story among legal scholars about this expression of naked egalitarianism—that it was either a triumphant or seditious idea (depending on perspective) that had its moment in the sun in the 1970s, but which the Supreme Court put to death 12 years later in Chiarella v. United States.  In a forthcoming article (part of a symposium on TGS to appear in the SMU Law Review, available here), I look back, as a matter of legal archeology if nothing else, on the pathway from TGS to Chiarella and beyond, and show that the real story is much more complicated. ...

In the early post-TGS cases, the commission seemed much more interested in building out its vision than pursuing egalitarianism per se.  It was bolstered in this by a counter-narrative at the time that TGS didn’t really mean what it said,[4] which got further traction in the mid-1970s as the American Law Institute—with the support of the securities law establishment—sought to recodify the regulatory infrastructure, including insider trading.  The Federal Securities Code rejected the egalitarian approach as not an apt reflection of then-current law.  There was also political pushback, naturally enough, especially given the threat of draconian private damage liability and the recognition that loose language in TGS could be put to use in upsetting many lucrative “market information” practices on Wall Street.  Suffice it to say that by 1976, the SEC—in a well-publicized speech by Commissioner Philip Loomis, who had argued TGS in the Second Circuit—explicitly disavowed market egalitarianism as neither good law nor good policy.

There are more intriguing archeological details, but this is enough to make it curious that the Supreme Court in Chiarella resurrected egalitarianism in order to kill it again.  (The Second Circuit decision on review had also disavowed mere possession as a source of duty). My impression is that Wall Street used it as a boogeyman, and that lawyers in the Solicitor General’s Office (perhaps still under the spell of Frank Easterbrook) were content to let it be so used because they wanted to reorient insider trading law away from anything like TGS or Cady Roberts.  Thus we got the strange—and entirely inaccurate—claim from Justice Lewis Powell that “we cannot affirm petitioner’s conviction without recognizing a general duty between all participants in market transactions to forego actions based on material, nonpublic information.”[5]  His narrower fiduciary duty test, supposedly needed to counter rampant egalitarianism, was a choice, not a necessity.

In the article, Don notes (at 4 n.14):

As Steve Bainbridge points out in his criticism of TGS in this symposium the key paragraph that promotes marketplace egalitarianism contains non-sequiturs, overbroad language and one-off citations, obscuring the inventiveness of the philosophy being promoted. Stephen M. Bainbridge, Equal Access to Information: The Fraud at the Heart of Texas Gulf Sulphur (this volume). Bainbridge thus concludes that the opinion was a fraud of its own, so that it and all the case law that followed were (and are) illegitimate. Though I agree that the bold proclamation of an egalitarian ideal and resulting disclosure duty was new to TGS, I disagree about the illegitimacy, for reasons explained herein.

The article to which Don is referring is Equal Access to Information: The Fraud at the Heart of Texas Gulf Sulphur (August 7, 2017). UCLA School of Law, Law-Econ Research Paper No. 17-14. Available at SSRN: https://ssrn.com/abstract=3014977:

The Texas Gulf Sulphur decision was the seminal moment in the creation of the modern federal insider trading prohibition. In the half century since it was decided, however, courts and commentators have overlooked the glaring flaw in the court’s analysis.

In the key part of the opinion, in which the court laid out the equal access standard, the court grossly misrepresented the precedents on which it relied. The court cited two state law opinions that were wholly irrelevant to the problem at hand. It cited two law review articles, but those articles simply do not say what the court claimed they said. Finally, the court made a bald, unsupported statement of Congressional intent that is demonstrably false.

The insider trading prohibition thus rests on a foundation of sand.

Setting aside our disagreement about the legitimacy of the moves made by the TGS court, I concur with Don's observation that Powell's fiduciary duty-based regime was not necessitated by section 10(b). In my article, Regulating Insider Trading in the Post-Fiduciary Duty Era: Equal Access or Property Rights? (May 8, 2012). UCLA School of Law, Law-Econ Research Paper No. 12-08. Available at SSRN: https://ssrn.com/abstract=2054814, I argued that:

Like equal access, the fiduciary duty approach lacked any basis in the text or legislative history of the statute and rule. Like equal access, precedent weakly supported Powell’s approach. Instead, like equal access, basing insider trading liability on a fiduciary duty to disclose was essentially a matter of judicial fiat. It was the deference his colleagues paid Powell on securities law matters that turned it into law, rather than its intrinsic merits. Unlike equal access, however, Powell’s approach lacked any obvious link to the purposes of the securities laws and, moreover, created a clear conflict with the federalism-based limits on those laws.