Friday, August 6, 2021
Testing Our Intuitions About Insider Trading - Part I
In January of 2020, The Bharara Task Force on Insider Trading released its report recommending that Congress adopt sweeping reforms of our insider trading enforcement regime. And it appears there is at least some momentum building to act on this recommendation. In April of 2021, the House of Representatives passed the Promoting Transparent Standards for Corporate Insiders Act, and in May of 2021, the House passed the Insider Trading Prohibition Act. I have expressed some concerns about these bills (see, e.g., here and here). But, as I argue in my book, Insider Trading: Law, Ethics, and Reform, I am in complete agreement with the claim that our current insider trading regime is broken and needs to be reformed.
We should not, however, rush to adopt a new insider trading regime without first thoughtfully considering what constitutes insider trading; why it is wrong; who is harmed by it; and the nature and extent of the harm. The answers to these questions have been subject to endless academic debate, but are crucial for determining whether insider trading should be regulated civilly and/or criminally (or not at all), as well as for determining the nature and magnitude of any sanctions to be imposed.
Historically, insider trading regimes around the globe can be grouped (roughly) into four categories (listed from the least to most restrictive): (a) laissez-faire regimes, which permit all trading on information asymmetries, so long as there is no affirmative fraud (actual misrepresentations or concealment); (b) fiduciary-fraud regimes, which recognize a duty to disclose or abstain from trading, but only for those who share a recognized duty of trust and confidence (with either the counterparty to the trade, or with the source of the information, or both); (c) equal-access regimes, which preclude trading by those who have acquired information advantages by virtue of their privileged access to sources that are structurally closed to other market participants (regardless of whether such trading violates a duty of trust and confidence); and (d) parity-of-information regimes, which strive to prohibit all trading on material nonpublic information (regardless of the source).
The following scenario illustrates conduct that would expose the trader to liability under a parity-of-information regime, but not under an equal access, fiduciary-fraud, or laissez-faire regime. As you read through the fact pattern, ask yourself: (1) Is this trading wrong? (2) Who (if anyone) is harmed by it? (3) What is the nature and extent of the harm? (4) Should this trading be regulated (civilly or criminally)? (Please share any answers/thoughts in the comments below!):
A high-school janitor is traveling home from work late at night on a public bus. She looks down and sees a trampled piece of paper. She picks up the paper and reads it. It appears to be someone’s notes from a meeting—though there is nothing to identify the paper’s owner/author. The paper reads as follows:
Meet at HQ of XYZ Corp at 3PM on Jan. 3 to finalize the merger with BIG Corp. Merger to be announced to public on Jan 10. Note: the announcement of merger will send shares of XYZ through the roof, so everyone must maintain strict confidentiality.
The janitor looks up and sees the bus is totally empty. There is no chance of finding the person who dropped the paper. It is January 4. The janitor opens an online brokerage account when she gets home and buys as many shares of XYZ Corp as she can afford. She makes huge profits when the merger is announced on January 10.
If you do not think the janitor has done anything wrong or harmful in this scenario, then you will probably not favor the parity-of-information model for insider trading regulation—which would render this conduct illegal. You will likely favor some version of one of the other insider-trading models instead. My next post will offer a scenario to test our intuitions about the equal-access model (the second-most restrictive regime).
The hope is that walking through these scenarios will help bring some clarity to our shared understanding of when trading on material nonpublic information is wrong and harmful—and (given our answer to this question) the nature and extent to which it should be regulated.
Thanks for the great comment Mike! You were too modest to share a link to your latest work in this area, "Avoiding Wasteful Competition: The Real Reason to Prohibit Insider Trading," which is now up on SSRN and available here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3719546.
Since I plan to devote an entire futute post to your paper, I will only note here that yours is precisely the type of concern that I would expect to motivate a broad parity-of-information enforcement regime like we find in Australia and Europe. That said, even if the wasteful competition illustrated by your follow-on example justifies deterrence through some regulation, my own intuition is that such conduct does not warrant any criminal sanction because I struggle to find anything unethical in the behavior.
Posted by: John A. | Aug 20, 2021 12:46:53 PM
Hi John. I hope it is not too late to comment. My observation would be that in your hypothetical you have nicely found a way to avoid engaging with the costs of wasteful competition that my analysis of insider trading is concerned about. The protagonist in your story makes no special effort to uncover the material nonpublic information, and the company does nothing special to try and hide the information.
In my follow-on hypothetical, after this trading success our protagonist realizes how profitable access to inside information can be. She hires a team of a thousand people who spend day and night searching busses and trains for similar pieces of paper. The operation is profitable. The companies whose information she is securing may ignore the early trading on information that is about to be released or may be concerned that somehow information they had hoped to keep secret for a day or two is being uncovered early. A concerned company may take countermeasures to keep information that is about to be released hidden and an arms race is engaged between those seeking information a day or two early and those trying to hide it. Note that these two parties are not in privity of contract so it may be quite difficult for them to avoid this arms race even if they wanted to do so through private ordering. Perhaps the companies could just sell early release of the information, but the possibility will always exist for a third party to get access to the information that much earlier. Thoughts?
I might also add that the regime I recommend, like the European regime with trading on certain categories of information prohibited, an extension of the Rule 14 prohibitions in the United States, does not seem to fit into your categorization of the four types of prohibitions that might make sense.
Posted by: Michael Guttentag | Aug 19, 2021 4:16:18 PM