Kevin Douglas on "Has the Strong-Form of the Efficient Capital Market Hypothesis Crept into U.S. Securities Regulation?"

In the fall, I posted on Professor Kevin R. Douglas's article, "How Creepy Concepts Undermine Effective Insider Trading Reform" (linked below), which is now forthcoming in the Journal of Corporation Law. The following post comes from Professor Douglas. In it, he develops one theme from that article:

Would U.S. officials imprison real people for failing to adhere to the most unrealistic assumptions in prominent economic models? Yes, if the assumption is that no one can generate risk-free profits when trading in efficient capital markets. What are risk-free profits, and why should you go to jail for trying to generate them? Relying on the ordinary dictionary definition of “risk” makes the justification for criminal penalties described above seem absurd. One dictionary defines risk as “the possibility of loss, injury, or other adverse or unwelcome circumstance,” and another simply defines risk as “the possibility of something bad happening.” Why should someone face criminal liability for attempting to generate trading profits without something bad happening—without losing money? The absurdity is especially jarring when thinking about securities markets, where hedge fund managers rely heavily on risk reduction strategies.

However, if we turn to the definition of “risk” used in prominent models of the efficient capital market hypothesis (ECMH), punishing investors who attempt to generate risk-free profits seems logical, if not sensible. The ECMH is the hypothesis that securities prices reflect all available information. Additional assumptions transform this hypothesis into the implication “that it is impossible to beat the market consistently on a risk-adjusted basis since market prices should only react to new information.” Here “beat the market” means generating profits that are greater than the returns of some index of the market. With these assumptions in mind, criminalizing the attempt to generate no-risk profits can seem logical if the existence of no-risk profits indicates market inefficiencies…and we accept that a proper role of government is increasing the efficiency of securities markets. Whether or not this approach is sensible depends on whether this model of risk bears any resemblance to anything operating in the real world. And even Eugene Fama who is thought of as the father of the ECMH, acknowledges that the model “is obviously an extreme null hypothesis. And, like any other extreme null hypothesis, we do not expect it to be literally true.”

Sensible or not, I argue that U.S. courts have relied on the ECMH’s model of risk for almost 60 years. Consider just one of several examples cataloged in my forthcoming article, How Creepy Concepts Undermine Effective Insider Trading Reform. The Court in SEC v. Texas Gulf Sulphur Co. provides the following justification for imposing insider trading liability under Rule 10b-5:

It was the intent of Congress that all members of the investing public should be subject to identical market risks,—which market risks include, of course the risk that one’s evaluative capacity or one’s capital available to put at risk may exceed another’s capacity or capital. … [However] inequities based upon unequal access to knowledge should not be shrugged off as inevitable in our way of life, or, in view of the congressional concern in the area, remain uncorrected.

It may seem arbitrary to expect equal “risk” for market participants to mean equality of information, but not equality of capital or skill. However, this disconnect is in harmony with models of market efficiency that focus on whether securities prices always “fully reflect” available information. Other cases identifying the attempt to generate risk-free profits to justify imposing liability for insider trading include two cases related to Ivan Boesky and Michael Milken, and Justice Ruth Bader Ginsburg’s majority opinion in United States v. O’Hagan. To differentiate acceptable and unacceptable information advantages, Justice Ginsburg states that the “misappropriation theory targets information of a sort that misappropriators ordinarily capitalize upon to gain no-risk profits through the purchase or sale of securities.”

Can explaining liability for securities fraud by reference to “risk-free profits” mean anything other than the implicit adoption of the strong form of the ECMH? If prominent economic models inspire the reference to risk-free profits in these cases, then it is astounding how little has been said about this fact. It was a big deal when the United States Supreme Court relied on some assumptions of the semi-strong form of the ECMH to justify adopting the fraud on the market theory. It is puzzling how quietly this feature of the ECMH crept into the insider trading case law.