Friday, June 24, 2022
Rethinking Insider Trading Compliance Policies in Light of the SEC's New "Shadow Trading" Theory of Insider Trading Liability
In August 2021, the SEC announced that it had charged Matthew Panuwat with insider trading in violation of Section 10(b) of the Securities Exchange Act of 1934. Panuwat was the head of business development at Medivation, a mid-sized biopharmaceutical company when he learned that his company was set to be acquired by Pfizer at a significant premium.
If Panuwat had purchased Medivation stock in advance of the announcement of the acquisition, it is likely he would have been liable for insider trading under the classical theory. Liability for insider trading under the classical theory arises when a firm issuing stock, its employees, or its other agents strive to benefit from trading (or tipping others who then trade) that firm’s stock based on material nonpublic information. Here the insider (or constructive insider) violates a fiduciary duty to the counterparty to the transaction (the firm’s current or prospective shareholders) by not disclosing the information advantage drawn from the firm’s material nonpublic information in advance of the trade.
If Panuwat had purchased shares of Pfizer in advance of the announcement, then it is likely he would have been liable under the misappropriation theory. Liability for insider trading under the misappropriation theory arises when one misappropriates material nonpublic information and trades (or tips another who trades) on it without first disclosing the intent to trade to the information’s source. As the Supreme Court held in United States v. O’Hagan, 521 U.S. 642, 652 (1997), the “misappropriation theory premises liability on a fiduciary-turned-trader’s deception of those who entrusted him with access to confidential information” by duping them out of “the exclusive use of that information.”
But Panuwat did not trade in either Medivation or Pfizer. Instead, he purchased stock options in Incyte, another pharmaceutical company that was similar in size and market focus to Medivation. According to the SEC’s litigation release, “Panuwat knew that investment bankers had cited Incyte as a comparable company in discussions with Medivation and he anticipated that the acquisition of Medivation would likely lead to an increase in Incyte’s stock price.” Panuwat’s gamble paid off. Incyte’s stock price increased 8% when Pfizer’s acquisition of Medivation was announced. Panuwat earned $107,066 from his trade.
Panuwat moved to dismiss the SEC’s insider trading charges, arguing that his trading in the shares of an unrelated third-party issuer did not violate any recognized theory of insider trading liability. While the district court acknowledged this was a case of first impression, it denied Panuwat’s motion and permitted the SEC to proceed with its first enforcement action under the "shadow trading" theory of insider trading liability.
The principal basis for the court’s decision seems to be that Panuwat’s trading arguably violated the misappropriation theory by breaching the broad terms of Medivation’s insider trading policy, which includes the following language:
During the course of your employment…with the Company, you may receive important information that is not yet publicly disseminated…about the Company. … Because of your access to this information, you may be in a position to profit financially by buying or selling or in some other way dealing in the Company’s securities…or the securities of another publicly traded company, including all significant collaborators, customers, partners, suppliers, or competitors of the Company. … For anyone to use such information to gain personal benefit is illegal.
To me, the most interesting question raised by the Panuwat case, and the problem of shadow trading more generally, is why would Medivation (or any company) adopt such a broadly worded insider trading policy? How did this broad proscription on employee trading benefit Medivation’s shareholders?
Medivation’s shareholders could not have been harmed by Panuawat’s trading. Such trading could not affect Medivation’s stock price, nor could it put the acquisition in jeopardy. So why is the blanket proscription against trading in “another publicly traded company” in the policy at all? The final sentence of the policy as quoted above suggests that the drafters were under the impression that such trading would be illegal under the securities laws. This may be true under the misappropriation theory, but only because Medivation chose to make it so by including the language in the policy. What if Medivation’s policy had instead provided something like the following language:
Because of your access to this information, you may be in a position to profit financially by trading in the Company’s securities, or the securities of its customers and suppliers. Such trading is strictly prohibited. Nothing in this policy should, however, be read as prohibiting your trading or dealing in any other issuers’ securities unless expressly restricted by the Company.
Under this policy, the SEC would have had no basis for the charge that Panuwat’s trading violated the misappropriation theory. In other words, it is entirely up to issuers whether they want to expose themselves and their employees to “shadow trading” liability. But if such exposure to liability does not benefit an issuer’s own shareholders, it can only hurt them (by needlessly exposing the company’s employees and the company itself to direct or derivative insider trading liability). So what business justification is there for issuers to include the broader language in their insider trading compliance policies? I hope readers will offer their thoughts in the comments below.
Friday, June 10, 2022
There have been number of recent BLPB posts representing a diversity of viewpoints concerning the SEC's proposed rule to "Enhance and Standardize Climate-Related Disclosures for Investors". For example, co-blogger Joan MacLeod Heminway recently posted on a comment letter drafted by Jill E. FIsch, George S. Georgiev, Donna Nagy, and Cynthia A. WIlliams (and signed by Joan and 24 others) that affirms the proposed rule is within the SEC's rulemaking authority. I have offered a couple posts raising concerns about the proposed rule from the standpoint of utility and legal authority (see here and here). One of the concerns I have raised is that the SEC's proposed disclosure regime may compel corporate speech in a manner that runs afoul of the First Amendment. SEC Commissioner Hester Pierce raised this same concern, and now Professor Sean J. Griffith has posted a new article, "What's 'Controversial' About ESG? A Theory of Compelled Commercial Speech under the First Amendment", which offers a more comprehensive treatment of this problem. Professor Griffith has also submitted a comment letter to the SEC raising this issue. Here's the abstract for Professor Griffith's article:
This Article uses the SEC’s recent foray into ESG to illuminate ambiguities in First Amendment doctrine. Situating mandatory disclosure regulations within the compelled commercial speech paradigm, it identifies the doctrinal hinge as “controversy.” Rules compelling commercial speech receive deferential judicial review provided they are purely factual and uncontroversial. The Article argues that this requirement operates as a pretext check, preventing regulators from exceeding the plausible limits of the consumer protection rationale.
Applied to securities regulation, the compelled commercial speech paradigm requires the SEC to justify disclosure mandates as a form of investor protection. The Article argues that investor protection must be conceived on a class basis—the interests of investors qua investors rather than focusing on the idiosyncratic preferences of individuals or groups of investors. Disclosure mandates that are uncontroversially motivated to protect investors are eligible for deferential judicial review. Disclosure mandates failing this test must survive a form of heightened scrutiny.
The SEC’s recently proposed climate disclosure rules fail to satisfy these requirements. Instead, the proposed climate rules create controversy by imposing a political viewpoint, by advancing an interest group agenda at the expense of investors generally, and by redefining concepts at the core of securities regulation. Having created controversy, the proposed rules are ineligible for deferential judicial review. Instead, a form of heightened scrutiny applies, under which they will likely be invalidated. Much of the ESG agenda would suffer the same fate, as would a small number of existing regulations, such as shareholder proposals under Rule 14a-8. However, the vast majority of the SEC’s disclosure mandates, which aim at eliciting only financially relevant information, would survive.
Friday, May 27, 2022
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.
Friday, May 13, 2022
Earlier this month, I came across a fun Wall Street Journal article, "Great Novels About Business: How Much Do You Know?" The article got me thinking about business-themed novels more generally. What are the greatest all-time novels about business? I came across another, related article from Inc.com that offers the following list of the 10 best classic novels about business:
- The Financier by Theodore Dreiser
- The Rise of David Levinsky by Abraham Cahan
- The Magnificent Ambersons by Both Tarkington
- The Old Wives' Tale by Arnold Bennett
- The Buddenbrooks by Thomas Mann
- North and South by Elizabeth Gaskell
- Atlas Shrugged by Ayn Rand
- JR by William Gaddis
- American Pastoral by Philip Roth
- Nice Work by David Lodge
I have to admit that I've yet to read a few of these books, and I plan to add them to my summer reading list. But I'm also surprised to find at least one book missing, A Christmas Carol by Charles Dickens. How could we leave Scrooge, Marley, and old Fezziwig off the list.....
"But you were always a good man of business, Jacob," faultered Scrooge, who now began to apply this to himself.
"Business!" cried the Ghost, wringing its hands again. "Mankind was my business. The common welfare was my business; charity, mercy, forebearance, and benevolence, were, all, my business. The dealings of my trade were but a drop of water in the comprehensive ocean of my business!"
Can you think of other novels that should be added--or some that should be removed from the list above? Please share your thoughts in the comments--and share some lines from your favorite business-themed novels!
Thursday, May 5, 2022
The Southeastern Association of Law Schools is holding its annual conference in Sandestin, Florida from July 27 through August 3. The current draft program is available here. I hope a number of you are planning to come.
In addition to my usual co-moderation (with the inimitable John Anderson) of an insider trading discussion group at the conference, I am looking to moderate the following discussion group:
Elon Musk and the Law
Moderator: Joan Heminway, The University of Tennessee College of Law
Enigmatic entrepreneur Elon Musk has found himself—and his businesses and his family—in the crosshairs of law and regulation. The legal and regulatory issues span a wide range, including First Amendment questions, securities disclosure challenges, legal contests involving the name of his son born in 2020 (with the musician Grimes), and more. This discussion group aims to identify, classify, and analyze these legal and regulatory interactions and interpret their effects on law reform, regulatory entrepreneurship, legal and administrative process, business venturing, and other areas of inquiry. Comparisons to and contrasting views of other public figures and their legal and regulatory tangles may be explored in the process.
Email me if you are interested in participating.
Also, I wish all a feliz Cinco de Mayo. Wikipedia reminds me that Cinco de Mayo is both a celebration of Mexican-American food and culture in the United States and a commemoration of "Mexico's victory over the Second French Empire at the Battle of Puebla in 1862." The Wikipedia article notes that "[t]he victory of a smaller, poorly equipped Mexican force against the larger and better-armed French army was a morale boost for the Mexicans." Ukraine immediately comes to mind. And I guess (feebly tying all this back to Elon Musk) one could take the view that a smaller, poorly equipped Twitter lost out to a larger and better armed acquiror in it recent kerfuffle-turned-takeover-battle with Elon Musk . . . . I know many of us will continue to have commentary on the Twitter acquisition as the transaction proceeds.
Friday, April 29, 2022
"We Know Wrongful Trading When We See It" - Some Observations Concerning the Recent Senate Hearing on the Insider Trading Prohibition Act
Earlier this month, the U.S. Senate Committee on Banking, Housing, and Urban Affairs held a hearing on the Insider Trading Prohibition Act (ITPA), which passed the house with bipartisan support in May of last year. Some prominent scholars, like Professor Stephen Bainbridge, have criticized the ITPA as ambiguous in its text and overbroad in its application, while others, like Professor John Coffee, have expressed concern that it does not go far enough (mostly because the bill retains the “personal benefit” requirement for tipper-tippee liability).
My own view is that there are some good, bad, and ugly aspects of the bill. Starting with what’s good about the bill:
- If made law, the ITPA would end what Professor Jeanne L. Schroeder calls the “jurisprudential scandal that insider trading is largely a common law federal offense” by codifying its elements.
- The ITPA would bring trading on stolen information that is not acquired by deception (e.g., information acquired by breaking into a file cabinet or hacking a computer) within its scope. Such conduct would not incur Section 10b insider trading liability under the current enforcement regime.
- The ITPA at least purports (more on this below) to only proscribe “wrongful” trading, or trading on information that is “obtained wrongfully.” Since violations of our insider trading laws incur criminal liability and stiff penalties, I have argued for some time that liability should be limited to conduct that is morally wrongful.
- The ITPA preserves the “personal benefit” test as a limiting principal on what otherwise would be an ambiguous and potentially overbroad test for when tipping would breach a fiduciary or similar duty of trust and confidence. Traders need (and justice demands) bright lines that will allow them to determine ex ante whether their trading is legal or will incur 20 years of prison time (but more on this below).
Now, turning to what is bad about the bill, I share some concerns raised by Professor Todd Henderson in his testimony before the Senate Committee:
- Though the ITPA codifies the personal benefit test as a limit on liability, it includes “indirect personal benefit[s]” within its scope. As Henderson points out, “[i]t is possible to describe virtually any human interaction as providing an ‘indirect benefit’ to the participants. Instead, the law should reflect the common sense notion that the source of information either received something tangible and valuable in return or what amounts to a monetary gift to a relative or friend.” The personal benefit test only fulfills its intended function as a limiting principle if it imposes real limits on liability. The test should therefore only be satisfied by objective evidence of self-dealing. If indirect psychological or other benefits that can be found in any voluntary human action can satisfy the test, then it cannot function as a limit on liability.
- At least some versions of the ITPA include a catchall provision to the definition of wrongfully obtained or used information that would include “a breach of a confidentiality agreement, [or] a breach of contract.” Not only does this challenge the time-honored concept of efficient breach in the law of contracts, but as Professor Andrew Verstein has argued, this provision can open the door to the weaponization of insider trading law through the practice of “strategic tipping.” Professor Henderson raised this concern before the Senate committee, noting that so broad an understanding of wrongful trading is “ripe for abuse, with companies potentially able to prevent individual investors from trading merely by providing them with information whether they want it or not.” The recent examples of Mark Cuban and David Einhorn come to mind.
- The ITPA would impose criminal liability for “reckless” conduct. As Henderson explained to the Committee, under the ITPA, “anyone who ‘was aware, consciously avoided being aware, or recklessly disregarded’ that the information was wrongfully obtained or communicated can have a case brought against them. The ITPA is silent on the meaning of ‘recklessly disregarded,’ which would appear to rope in innocent traders along with actual wrongdoers.” Moreover, permitting mere recklessness to satisfy the mens rea element of insider trading liability will no doubt have a chilling effect on good-faith transactions based on market rumors that would otherwise be value enhancing for traders, their clients, and the markets. The loss of such trades will diminish market liquidity and reduce price accuracy.
- Finally, Henderson raised the concern that the ITPA lacks an “exclusivity clause stating that it will be the sole basis for bringing federal insider trading claims.” Henderson explained that “allowing prosecutors to cherry pick their preferred law is no way to provide clear rules for the market.” Professor Karen Woody has written about how prosecutors may be starting to bring insider trading cases under 18 U.S.C. § 1348 to avoid the court-imposed personal benefit test under Exchange Act §10b. Without an exclusivity clause, prosecutors will be free to make the same end run around the personal benefit test imposed by the ITPA.
Finally, the ITPA is straight-up ugly because, while it promises that it will limit insider trading liability (which can be punished by up to 20 years imprisonment) to only “wrongful” conduct, the bill defines the term “wrongful” in a way that suggests the drafters have no intention of delivering on that promise. For example, as noted above, some versions of the bill define any breach of contract as “wrongful,” but this is in clear tension with common sense, common law, and the doctrine of efficient breach.
In addition, though there is ambiguity in the text, current versions of the ITPA appear to embrace SEC Rule 10b5-1’s “awareness” test for when trading on material nonpublic information incurs insider trading liability. Under the awareness test, a corporate insider incurs insider trading liability if she is aware of material nonpublic information while trading for totally unrelated reasons. In other words, liability may be imposed even if the material nonpublic information played no motivational role in the decision to trade. But if the material nonpublic information played no motivational role, then the trading cannot be judged “wrongful” under any common-sense understanding of that term.
For these (and other reasons there is no space to address here), the ITPA leaves too much room for play in its definition of what constitutes “wrongful” trading and tipping to cohere with our common-sense understanding of that term. Former SEC Commission Robert J. Jackson assured the Committee that “we know wrongful trading when we see it.” Presumably Professor Jackson’s implication was that the SEC and DOJ can be trusted to exercise sound discretion in interpreting the play in the statutory language. In response, I offer the following question for Professor Jackson or any reader of the ITPA to consider: Would issuer-licensed insider trading violate the statute? I have defined “issuer licensed insider trading” as occurring where:
(1) the insider submits a written plan to the firm that details the proposed trade(s);
(2) the firm authorizes that plan;
(3) the firm has previously disclosed to the investing public that it will permit its employees to trade on the firm’s material nonpublic information when it is in the interest of the firm to grant such permission; and
(4) the firm discloses ex post all trading profits resulting from the execution of these plans.
I have argued that trading under these conditions is neither morally wrongful nor harmful to markets. If it violates ITPA, what provisions? I hope some readers will share their thoughts on this in the comments below!
Friday, April 15, 2022
Shortly after President Barack Obama’s first press conference in 2009, the Huffington Post published an article, "When Did You Stop Beating Your Wife?", that challenged the false premises of many of the questions being asked of the new president. The article opens by noting:
Sooner or later every human being on the face of this planet is confronted with tough questions. One of the toughest and most common is the infamous loaded question, “when did you stop beating your wife?” which implies that you have indeed been beating your wife. How do you answer without agreeing with the implication? How do you not answer without appearing evasive?
The author’s solution is that you should refuse to answer the question by simply responding, “no,” or by challenging the false assumption imbedded in the question. But what if the question is not asked at a press conference, by opposing counsel in the courtroom, or at a cocktail party, but as part of a federally mandated disclosure regime? This is a dilemma issuers may face if the Securities and Exchange Commission’s (SEC’s) proposed rule to "Enhance and Standardize Climate-Related Disclosures for Investors" is adopted.
Existing SEC disclosure rules and guidance already require that issuers disclose man-made-climate-change-related risks that would materially impact market participants’ investment decisions concerning the company. Nevertheless, the SEC has determined that the existing regime grants boards too much discretion in deciding whether and how to disclose climate risk—which has resulted in climate-related disclosures that are insufficiently "consistent," "comparable," and "clear."
The SEC’s proposed changes to the disclosure regime would compel all publicly-traded companies to answer specific, standardized climate-related questions concerning, for example, the physical risks of human-caused-climate-related events (e.g., “severe weather events and other natural conditions”) on their business models and earnings in a manner that will be consistent and comparable with the answers of the thousands of other regulated issuers. But what if the boards’ honest answers to these difficult questions cannot be made to fit the SEC’s proposed one-size-fits-all mold? What if some issuers question the premises of the questions?
What if, for example, a board is not convinced that extreme weather events such as hurricanes, tornadoes, wildfires, droughts, etc., can be traced directly to human versus non-human causes? In such circumstances, mandatory reporting on either transitional or physical risks due to human-caused climate change might look a lot like mandatory disclosures on questions like “When did you stop beating your spouse?” Can issuers satisfy the SEC’s reporting requirements by simply answering “no,” as the Huffington Post author suggested President Obama should have answered such questions, or by challenging the premise of the question?
There is no doubt that the extent, effects, and appropriate response to human-caused-climate change is a partisan issue in the United States. One Vanderbilt survey found that 77.3% of respondents who identify as “liberal” believe that climate change is a serious problem, but only 17.2% of those who identify as “conservative” regard climate change as a serious problem. Moreover, the division over the impacts and appropriate responses to climate change are not just political—they exist in the scientific community as well. For example, Steven E. Koonin, a former Undersecretary for Science in the U.S. Department of Energy under President Obama, and member of the Academy of Sciences, recently published a book, Unsettled: What Climate Science Tells Us, What It Doesn’t, and Why It Matters, which questions a number of the premises informing the SEC’s proposed disclosure regime.
Take, as just one example, the proposed rule’s mandatory disclosure of “physical” risks to issuers due to extreme weather events resulting from human-caused-climate change. The home page of the Task Force on Climate-Related Financial Disclosures, which the SEC credits as a principal source for its proposed rule, includes a video presentation by former Democratic Presidential Candidate, Michael Bloomberg, stating that climate change is a “crisis that shocked the [financial] system” in 2021: “wildfires, heat, flooding, and other extreme weather events have devastated communities and cost trillions of dollars this year alone.”
The premise of Bloomberg’s statement, which the SEC has effectively adopted, is that our models can reliably trace these extreme weather events to human causes. But is this true? Koonin points out that while a recent U.S. government climate report claims that heat waves across the U.S. have become more frequent since 1960, it “neglected to mention that the body of the report shows they are no more common today than they were in 1900.” Koonin also points out similar holes in common claims that human-caused climate change is responsible for extreme weather events like flooding, wildfires, and hurricanes. More fundamentally, Koonin argues that the new field of “event attribution science,” which provides the principal basis for claimed causal links between human influences and extreme weather events is “rife with issues,” and he is “appalled such studies are given credence, much less media coverage.”
None of the above should be interpreted as an attempt on my part to take sides in the climate debate. (I am no authority; my PhD is in philosophy, not in anything useful.) It is just to illustrate how these issues continue to be highly contested subjects of debate in both political and scientific circles.
The worry I raise here is that this sphere of discourse is far too contested and politically charged to be the subject of a mandatory disclosure regime. In response to challenges by Commissioner Hester Peirce and others that the SEC’s proposed rule on climate disclosure compels speech in a manner inconsistent with the First Amendment, Commissioner Gensler has responded that the reporting requirements do not mandate content. But, again, is this correct? If the disclosure questions are loaded, don’t they (at least implicitly) dictate the content of the response—particularly if the questions are carefully designed to elicit “standardized,” “consistent,” “comparable,” and “clear” answers?
Friday, April 1, 2022
Volume 14 of the William & Mary Business Law Review is currently accepting submissions for publication in 2022 and 2023. The Journal aims to publish cutting-edge legal scholarship and contribute to significant and exciting debates within the business community. Submissions for consideration can be sent via Scholastica, or if need be, via email to wm.blr.articlesubmission@
Tuesday, March 22, 2022
The following comes to us from Professor Mike Guttentag in response to my recent post on his excellent and thought-provoking new article, Avoiding Wasteful Competition: Why Trading on Inside Information Should be Illegal. This is a worhy discussion I look forward to continuing--and I hope others will engage in the comments below. Now, here is Professor Guttentag's response:
As always, I am honored and impressed by the seriousness and respect with which Professor Anderson approaches my work. I would, however, take exception to the reasons he offers for rejecting my conclusions.
The debate about insider trading over the past five decades has suffered from limited evidence of either benefits or harms. Those who have objected to a strict insider trading prohibition have reasonably asked: what evidence is there that the harms of insider trading justify a broad prohibition?
In my article I believe I have answered that challenge. First, I explain why there is a significant mismatch between private gains and social gains when trading on inside information. This mismatch arises both because of how inside information is produced (largely as a byproduct of other activities) and how trading on this information generates profits (at the expense of others). I next show how this mismatch between private gains and social gains (perhaps the defining economic feature of insider trading) leads to an unusual problem: the problem of too much or wasteful competition. This is not just a theoretical concern. I offer concrete estimates of the magnitude of the costs of this wasteful competition problem. One very conservative estimate puts the costs of wasteful competition in United States equity markets in the range of tens of billions of dollars a year. The logic is compelling, and the amounts involved substantial: insider trading is a socially wasteful activity that should be outlawed.
The time has now come for those who would do less than outlaw all trading when in possession of inside information to provide either equally compelling evidence of the benefits of an alternative regime or an explanation as to why my calculations are flawed. I do not believe that Anderson’s critiques meet either of these challenges.
I will go through Anderson’s critiques one by one. The first concern Anderson raises is that he believes my argument hinges on the claim that all inside information is produced as a byproduct of other activities. Anderson has read my argument as relying on a stronger claim than I think it needs to rely on. I do not aim to refute the vast body of work by the likes of Henry Manne and many, many others on the various costs and benefits of insider trading. These lists of the potential costs and benefits established over the past decades are largely correct. However, there are two problems with these lists. First, these lists have consistently failed to realize the magnitude and importance of the wasteful competition problem created by insider trading (I have addressed the reasons for this oversight elsewhere, Law and Surplus: Opportunities Missed). Second, once the costs of wasteful competition are included in the calculus the appropriate starting point shifts. Given how significant the wasteful competition problem is, we need more than just a list of plausible but hard-to-quantify costs and benefits to rebut the presumption that all trading when in possession of inside information should be outlawed. That is the extent of my claim.
The second point that Anderson raises in his comments is that he does not think I have carried out an adequate “comparative institutional approach to market failure.” In fact, I think I do a fair job in the article of addressing this question, and show, for example, why private ordering is not an effective alternative to legal intervention as a way to address the wasteful competition problem created by insider trading. Moreover, the correct comparison should be between the cost of our muddled and confused current regime and the simple proposal I offer, a proposal, by the way, that is similar to the insider trading prohibition already in place in Europe (albeit with less enforcement capability in Europe). I do not see what institution Anderson thinks could do a better job addressing the problem I have identified than the federal government. As a side note, if we want to minimize the kind of rent-seeking by government officials that Anderson also mentions, then a bright-line such as the one I propose might well be preferable to the murky waters that now surround the insider trading prohibition.
The third point Anderson raises is that he finds my consideration of internal compliance costs lacking. My response to this observation is: internal compliance costs as compared to what baseline? The current system is a quagmire, whereas the one I propose would be more straightforward to implement. It seems to me that when it comes to minimizing internal compliance costs my proposal is preferable to the status quo. But even if I am incorrect about the relative costs of internal compliance under different regulatory regimes the larger point remains: discussions of these kinds of second order, difficult-to-quantify cost simply do not offer enough evidence to justify accepting the costs of wasteful competition that a very conservative estimate puts in the range of tens of billions of dollars a year in only one marketplace.
The fourth point Anderson raises is yet another potential cost of my proposal as compared to the status quo. Anderson correctly points out that my rule may be over-inclusive and prevent some individuals from gathering and trading on information for which social gains are equal to or greater than private gains. This is true. However, again, where is the concrete evidence that these costs of over-inclusivity are anything near the magnitude of the quantifiable costs that result from wasteful competition. The evidence in support of a sweeping prohibition remains.
Finally, Anderson raises the specter of criminal punishment. I did not hope, as Anderson suggests, to fully “detach my model from the debate over the morality of insider trading.” I only rejected current efforts to base an insider trading prohibition on fairness concerns. In terms of advancing my own arguments, I felt that as a practical matter the topic of links between solutions to a wasteful competition problem and criminality was too vast to fit in an already long article. For those who are interested, I have begun to further explore these connections elsewhere in work on the relationships between evolutionary psychology and the use of law as a tool to share resources.
The one point I did make in the article relevant to the question of criminal liability for insider trading was to observe that engaging wasteful competition can trigger moral outrage in some circumstances. Such feelings can be observed, for example, when others react to people cutting in line. We have normative reactions to people who pursue their naked self-interest in situations where payoffs through cooperation are greater than those that can be realized through competition by, for example, refusing to honor a queue. Anderson investigates this analogy by asking about someone who has permission to cut in line. Presumably, he means to draw a parallel to issuer-sanctioned insider trading wherein firms allow employees to trade on material nonpublic information. The question of whether or how permission to cut in line might be granted is quite complex and is a topic for another day. I only hoped in this article to suggest why there might be a link between my conclusion that avoiding wasteful competition justifies an insider trading prohibition and the choice to criminalize insider trading.
Again, I truly appreciate Anderson’s honest engagement with my work. However, I think he fails to provide a compelling rebuttal. What we need now in the United States is a prohibition on all trading when in possession of inside information.
Friday, March 18, 2022
For some time now, the insider trading enforcement regime in the United States has been criticized by market participants, scholars, and jurists alike as lacking clarity, theoretical integrity, and a coherent rationale. One problem is that Congress has never enacted a statute that specifically defines “insider trading.” Instead, the current regime has been cobbled together on an ad hoc basis through the common law and administrative proceedings. As the recent Report of the Bharara Task Force on Insider Trading puts it, the absence of an insider trading statute “has left market participants without sufficient guidance on how to comport themselves, prosecutors and regulators with undue challenges in holding wrongful actors accountable, those accused of misconduct with burdens in defending themselves, and the public with reason to question the fairness and integrity of our securities markets.”
Congress appears to be responding, and a number of bills that would define insider trading and otherwise reform the enforcement regime are receiving bipartisan support. But it would be a mistake to pass new legislation without first taking the time to get clear on the economic and ethical reasons for regulating insider trading. This is particularly true in light of the fact that the general public is clearly ambivalent about whether and why insider trading should be regulated.
Mike Guttentag's new article, Avoiding Wasteful Competition: Why Trading on Inside Information Should Be Illegal, offers an important new (or at least heretofore underappreciated) lens through which the potential costs of insider trading may be identified. For Guttentag, inside information is generally created as a mere byproduct of otherwise productive economic activity. But though it takes no additional effort to create, it has significant economic value for those who can trade on it. The rush to capture this surplus results in “wasteful competition because competition for surplus (or rent-seeking in the terminology economists prefer) is both hard to prevent and inherently wasteful.” Absent comprehensive regulation of insider trading, vast resources would be wasted in efforts by market participants to capture what Guttentag estimates may amount to tens of billions of dollars in potential insider trading profits each year.
Since the problem of wasteful competition arises whenever trading with material nonpublic information is permitted, Guttentag recommends “(1) that federal insider trading legislation should be enacted that prohibits all trading on inside information regardless of whether the information is wrongfully acquired, (2) courts should not require proof that a tipper received a personal benefit to find tippers and tippees culpable, and (3) the mere possession of inside information should be sufficient to trigger a trading prohibition.”
Guttentag’s arguments are original and compelling, but I am not convinced they justify the reforms he proposes. Here are some of my reasons:
- First, Guttentag’s wasteful competition argument turns on the claim that all inside information is a mere byproduct of otherwise productive activity. But this seems to beg the question against Henry Manne and others who have argued that insider trading as compensation can be an effective incentive for entrepreneurship and innovation at firms. And this incentive can come at a savings to shareholders by reducing the need for other forms of compensation. If the production of inside information is part of the motivation behind innovation, it is not a surplus. Guttentag does address some (though not all) of Manne’s arguments concerning insider trading as compensation, but I would like to see a more complete treatment.
- Second, even if we are convinced that insider trading drives wasteful rent-seeking, I’m not sure Guttentag has shown that the broad enforcement regime he recommends is the appropriate response. Under the comparative institutional approach to market failure, the proponent of regulation needs to show the regulation would improve matters. Rent-seekers come in all shapes and sizes, and government agencies such as the SEC are by no means immune to the temptation to engage in rent-seeking and rent-selling. Expanded authority would no doubt increase the opportunities and incentives for such wasteful action on the part of the regulators. Guttentag fails to address this concern.
- Third, Guttentag fails to acknowledge the internal compliance costs his proposed expansion of liability will impose on issuers. I address the significant costs of insider trading compliance in my article, Solving the Paradox of Insider Trading Compliance. I suspect these already significant costs (and incentives to rent-seek from regulators) would only increase under Guttentag’s proposed regime. This concern should be considered as part of a comparative institutional analysis.
- Fourth, Guttentag’s proposed reform would impose liability for trading while in possession of inside information even if that information played no part in the trading. But trading for reasons unrelated to inside information does not evidence wasteful competition for that information. Guttentag’s rationale cannot therefore justify this rule. He suggests that this mere possession rule can be justified as a prophylactic measure—simplifying enforcement of insider trading that does derive from wasteful competition. Guttentag fails, however, to consider the significant costs (e.g., in terms of [a] liquidity for those who are compensated with equity and [b] the preclusion of otherwise innocent, value-enhancing trades) the broad restriction would impose on the insiders, the issuers, and the market more broadly.
- Finally, Guttentag considers it a virtue of his wasteful competition model that it does not rely on any controversial claims regarding the ethics of insider trading to justify its regulation. His model imposes liability on those who trade while possessing inside information because it is wasteful—not because it is wrongful. But insider trading liability in the United States has historically carried stiff criminal penalties. Guttentag is comfortable with the idea that these penalties be imposed under his proposed regime as well. This makes me wonder what other criminal sanctions for morally innocent but wasteful behavior this logic might justify. Guttentag seems to anticipate this concern and hedges a bit by suggesting that wasteful behavior may not be morally innocent after all. He notes that, for example, those who engage in wasteful behavior like cutting in line typically elicit “strong feelings of moral disapproval.” First, this may be true, but what about those who ask permission to cut (for some good reason)—and receive that permission? Such persons’ behavior would be just as wasteful, but would probably not receive the same moral disapproval. Second, to the extent Guttentag considers detaching his model from the debate over the morality of insider trading, this line-cutting example pulls him right back in.
Despite these concerns, I am convinced that Guttentag’s new article advances the discussion about why insider trading is (or can be) harmful to markets and society. I recommend it to anyone who wishes to be educated on the subject. Here’s the abstract to Mike’s article:
This article offers a new and compelling reason to make all trading based on inside information illegal.
The value realized by trading on inside information is unusual in two respects. First, inside information is produced at little or no incremental cost and is nevertheless quite valuable. Second, profits made from trading on inside information come largely at the expense of others. When the value of something exceeds the cost to produce it, a wasteful race to be the first to capture the resulting surplus is likely to ensue. Similarly, resources expended solely to take something of value from others are wasted from an overall social welfare perspective. Thus, both at its source and in its use inside information invites wasteful competition. A law prohibiting insider trading is the best way to avoid this wasteful competition.
Previous scholarship misses this obvious conclusion because of its reliance on one of three assumptions. First, wasteful competition is assumed to be a problem that markets can rectify. Second, private ordering solutions are assumed to be available even when market mechanisms fail to address this problem. Third, a wasteful race to acquire and use inside information is viewed as otherwise unavoidable. None of these assumptions is correct.
The findings here have immediate policy implications. First, insider trading legislation should be enacted that bans all insider trading and not just trading based on wrongfully acquired information. Second, there is no reason to require proof that a tipper received a personal benefit to prosecute someone for tipping inside information. Third, the possession and not the use of inside information should be enough to trigger a trading prohibition.
Friday, March 4, 2022
The Law and Economics Center at the George Mason University Antonin Scalia School of law is hosting a Research Roundtable on Capitalism and the Rule of Law this week in Destin, Florida. My co-author, Professor Jeremy Kidd (Drake University School of Law) and I are honored to present a draft of our current work-in-progress, "Market Failure and Censorship in the Marketplace of Ideas," at tomorrow's (March 5, 2022) session. We look forward to receiving feedback from all the brilliant scholars in attendance. Here's an abstract of the current draft. We look forward to sharing a link to the full draft soon:
As one author notes, the familiar metaphor of the exchange of ideas as a “marketplace” has “permeate[d] the Supreme Court’s first amendment jurisprudence.” If the test for efficiency in the marketplace for goods is wealth maximization, the test for efficiency in the marketplace of ideas has historically been understood in terms of its ability to reliably arrive at truth, or at least the most socially beneficial ideas within the grasp of a community of discourse. And consistent with economic free-market advocates, the received expectation in Western liberal democracies has been that “a process of robust debate, if uninhibited by government [or other] interference, will” best achieve this end. In other words, the assumption is that the market of ideas is most efficient when it is free. As Thomas Jefferson famously claimed, “Truth is the proper and sufficient antagonist to error, and has nothing to fear from conflict, unless by human interposition, disarmed of her natural weapons, free argument and debate.” Similarly, Justice Oliver Wendell Holmes later noted, “the best test of truth is the power of thought to get itself accepted in the competition of the market.”
But even the most fervent economic free-market advocates recognize the possibility of market failure. Market failure is “a market characteristic that prevents the market from maximizing consumer welfare.” The exercise of monopoly power, for example, is a common source of market failure. Most economists agree that government or other regulatory interference with market freedom may be justified to correct a market failure.
The last few years have witnessed increased calls (from both government officials and the private sector) for censorship of speech and research pertaining to a variety of subjects (e.g., climate change; COVID-19 sources and treatments; and viewpoints concerning race, gender, and sexual orientation) across a variety of venues (e.g., social media, the classroom, internet searches, corporations, and even persons’ private bookshelves). The consistent refrain in favor of this censorship is that the spread of false or misleading information is preventing access to or distorting the truth and thereby inhibiting social progress: undermining democracy, fomenting bigotry, costing lives, and even threating the existence of the planet.
Do these increasing calls for censorship respond to a market failure in the marketplace of ideas? For example, could a majority race so dominate the terms of conditions of public and private discourse that minority voices are effectively barred from entry? If so, calls for censorship of expressly or implicitly racially biased voices may be an appropriate response to a market failure in the marketplace of ideas. If not, however, pervasive success at censorship (whether public or private) may itself create inefficiencies equivalent to market failure.
In this Article, the authors draw upon familiar economic principles to explore the possibility of market failure in the marketplace of ideas. The authors then rely on philosophical arguments articulated by liberal thinkers from John Milton and John Stuart Mill to Isaiah Berlin and Richard Rorty to argue (in response to classical and post-modern critiques) that the spread of false or misleading information does not on its own reflect a market failure warranting censorship as a corrective. Instead, it is argued recent successful efforts at silencing and deplatforming dissenting voices (particularly in the context of social media, but also in academia and the workplace) reflects the real market failure in need of correction.
The Article proceeds as follows: Part I offers examples of recent calls for (and efforts at) censorship in the market of ideas concerning a variety of subjects and forums. Part II explores the idea of the marketplace of ideas as an economic concept, defines its components, considers the possibility of associated market failures, and highlights some common fallacies in the application of the concept of market failure more broadly. Part III explores the principal philosophical arguments for the utility of freedom of expression, focusing on the arguments articulated in John Stuart Mill’s classic, On Liberty. Part IV argues that, in light of these arguments (and taking into account contemporary post-modern critiques), the threat of false and misleading expression does not reflect market failure in today’s marketplace of ideas. To the contrary, Part V argues that the ease with which recent public and private efforts at censorship have succeeded itself reflects a market failure warranting correction—if not through legislation or the courts, then by social sanction and the court of public opinion.
Friday, February 18, 2022
With a recent poll showing that 76 percent of voters think members of Congress have an "unfair advantage" in stock trades, I argued in my last post that Congress should adopt a broad rule against trading in individual stocks by sitting cogresspersons (and perhaps their spouses, children, and staff). I argued that such a move would go a long way toward restoring the perception that members of Congress are public servants, as opposed to the current perception shared by many voters that they are public parasites. In addition to restoring public confidence in the legislative branch, I argued adopting such a prophylactic against insider trading would also help improve public confidence in the integrity of our securities markets—a goal Congress has touted repeatedly for almost a century.
I have since posted a short paper on SSRN, Time for a Broad Prophylactic against Congressional Insider Trading, that develops these arguments. Part I offers a brief summary of the current state of insider trading laws, with a special focus on their application to Congress. Part II surveys some of the proposed insider trading reform bills under consideration. Part III argues that, given congresspersons’ unique role vis-à-vis securities markets, a broad prophylactic against congressional trading is both justified and needed.
Friday, February 4, 2022
Public Servants or Parasites? Why a Broad Prophylactic against Congressional Insider Trading Makes Sense
In 2011, Peter Schweizer published a book, Throw Them All Out, in which he exposed some questionable means by which (according to one study) politicians manage to increase their personal wealth 50% faster than the average American.
According to Schweizer, trading on material nonpublic information appears to be a popular method among congresspersons for achieving outsized returns on their investments. He cites one study finding:
- The average American investor underperforms the market.
- The average corporate insider, trading his own company’s stock, beats the market by 7% a year.
- The average senator beats the market by 12% a year.
Schweitzer’s book was followed by a feature story on the CBS News show, 60 Minutes, highlighting some dubious stock trades by leaders of both political parties. These stories got the public’s attention and spurred Congress to act—adopting the Stop Trading on Congressional Knowledge (STOCK) Act in April of 2012.
The STOCK Act made explicit what many already understood as implicit—that congressional trading based on material nonpublic information acquired by virtue of their position as a public servant was a breach of their fiduciary duties and would therefore violate Section 10b of the Securities Exchange Act of 1934. The Act also expanded disclosure requirements for members of Congress, the executive branch, and their staff members.
But no sooner had the STOCK Act passed than it was quietly overhauled to weaken certain of its key provisions, and, in any event, the Act has not been consistently enforced since its adoption. As a result, public cynicism concerning congressional insider trading has once again snowballed. For example, Speaker Nancy Pelosi's stock trades are monitored by popular Twitter, TikTok, and Reddit accounts with handles like "@NancyTracker," and the search “Pelosi stock trades” hit a record high on Google in January 2022.
Of course, Pelosi is not the only congressperson the public suspects of insider trading. For example, a number of U.S. Senators were scrutinized over suspicious stock trades as the threat of the COVID-19 pandemic emerged in 2020.
So what is to be done? Just as they did in 2011, members of Congress on both sides of the aisle are rushing to get out in front of the issue. A number of congressional insider trading reform bills have garnered bipartisan support. Many of these bills propose the broad prophylactic of proscribing members of congress from trading in individual stocks. Some bills would go so far as proscribing trades by spouses and dependent children as well.
There is precedent for broad prophylactics against insider trading. Consider, for example, Exchange Act Rule 14e-3, which permits civil and criminal liability for trading based on material nonpublic information concerning tender offers, even if there is no accompanying proof of fraud.
Though I have argued for reducing the scope of insider trading liability in some contexts (e.g., where such trading is licensed by the issuer of the stock being traded), I have consistently recognized misappropriation trading (such as when a congressperson misappropriates material nonpublic government information to trade for personal gain) as morally wrong, and as warranting civil and criminal sanctions. And I think extending the scope of liability for congressional insider trading with a broad prophylactic (e.g., proscribing all individual stock trades) is warranted for the following reasons (among others):
- Congresspersons are in a unique position to affect individual stock prices by introducing (and voting for) bills directly affecting those issuers, calling on the SEC to investigate issuers, or otherwise exerting their extensive political influence to affect markets. As one congressperson notes, "one line in a bill in Congress can be worth millions and millions of dollars."
- Congress’s influence over the SEC and DOJ makes aggressive enforcement by those agencies more challenging—and when actions are brought, there will always be the specter of political motivation. The broad prophylactic would simplify enforcement, and thereby mitigate these worries.
- Given the above concerns, even legitimate stock trades by members of Congress will be the subject of continued public suspicion and cynicism. Such suspicion undermines public confidence in the integrity of the legislative branch--and the markets.
- Protestations that a broad proscription of individual stock trading would be Un-American because "We're a free-market economy" and “[Members of Congress] should be able to participate in that” are totally unavailing. People voluntarily assume roles that deprive them of rights they would otherwise enjoy all the time (e.g., by joining the military), and public service has always been understood as just such a role.
- Members of congress should not be (significantly) financially disadvantaged by a rule precluding trades in individual stocks. Given the efficient market hypothesis (roughly, that an individual stock’s price always reflects all currently available public information about that stock), members of congress should not expect their individual stock trades to outperform a similar trade in, say, a mutual fund in any event….unless, that is, they have information that is NOT publicly available.... Diversification is typically the best long-term investment strategy.
The most recent ReacClearPolitics Poll Average shows that Congress currently enjoys the approval of 21% of Americans. If Congress would like to begin improving those numbers, I suggest it adopt one of the proposed insider trading bills proscribing individual stock trading by its members. This might go a long way toward restoring the perception that members of Congress are public servants, as opposed to the current perception shared by many Americans (justified or not) that they are public parasites.
Friday, January 7, 2022
We just wrapped up a fascinating discussion group titled "A Very Online Economy: Meme Trading, Bitcoin, and the Crisis of Trust and Value(s)--How Should the Law Respond?" as part of the AALS 2022 Annual Meeting. I co-moderated the group with Professor Martin Edwards (Belmont University School of Law). Here's the description:
Emergent forces emanating from social and financial technologies are challenging many underlying assumptions about the workings of markets, the nature of firms, and our social relationship with our economic institutions. Blockchain technologies challenge our assumptions about the need for centralization, trust, and financial institutions. Meme trading puts pressure on our assumptions about economic value and market processes. Environmental and social governance initiatives raise important questions about the relationship between economic institutions and social values. These issues will certainly drive policy debates about social and economic good in the coming years.
The group gathered some amazing presenters and commentators for the discussion, including:
- Prof. Eric Chaffee (University of Toledo School of Law)
- Prof. Kevin R. Douglas (Michigan State College of Law)
- Prof. Caleb N. Griffin (University of Arkansas School of Law)
- Prof. Yuliya Guseva (Rutgers Law School)
- Prof. Mike Guttentag (Loyola Law School)
- BLPB co-blogger, Prof. Joan MacLeod Heminway (University of Tennessee College of Law), who inspired and encouraged Martin and I to organize the group
- Prof. Ben Johnson (Penn State Law)
- Prof. Kristin Johnson (Emory Law)
- Prof. Jeremy Kidd (Drake University Law School)Prof.
- Prof. Seth C. Oranburg (Duquesne University School of Law)
- Prof. Carla L. Reyes (Southern Methodist University Dedman School of Law)
- Prof. J.W. Verrett (George Mason University Antonin Scalia Law School)
The discussion was lively and informative, and I look forward to seeing the final versions of these projects in print!
Friday, December 10, 2021
It is an exciting time for insider trading law. BLPB coblogger Joan MacLeod Heminway and I will be moderating a discussion group, New Challenges for Insider Trading Compliance, at the upcoming Southeastern Law Schools (SEALS) Annual Conference (July 27-August 3, 2022). The conference is scheduled to be held in person in Sandestin, Florida. Here's the description for our discussion group:
Insider trading law in the United States is in a state of flux and uncertainty. In May of 2021, the House of Representatives passed the Insider Trading Prohibition Act. If this bill becomes law, it will impose an entirely new statutory regime for civil and criminal enforcement. Moreover, Securities and Exchange Commission (SEC) Chairman Gary Gensler recently directed the staff to present recommendations to "freshen up" and tighten the operative provisions in Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. In response, in August of 2021, the SEC's Investor Advisory Committee proposed extensive new restrictions on the use of 10b5-1(c) trading plans as an affirmative defense for insider trading. Meanwhile, prosecutors and regulators continue to employ novel theories of liability in insider trading enforcement actions. Criminal enforcement actions under 18 U.S.C. § 1348 and civil enforcement under the novel "shadow trading" theory of liability are just two examples. How will these and other impending changes affect compliance departments at public companies and in the financial industry? How should the lawyers in these and other organizations prepare? Should market participants welcome these potential changes to our insider trading laws, or are there grounds for concern? This discussion group is designed to address these and other related questions.
There may still be room for additional participants. If you are a law (or business law) professor who is interested in joining the discussion in sunny Florida, don't hesitate to reach out to me at email@example.com.
Friday, November 26, 2021
I was recently honored to be invited to join a panel at the 16th Annual Meeting of the American College of Business Court Judges (ABCBJ), which was held in Jackson, Mississippi, on October 27-29. The meeting was hosted by Chancellor Denise Owens (the current president of the ACBCJ) in association with the Law & Economics Center (LEC) at George Mason University Antonin Scalia School of Law.
Chancellor Owens kicked off the event and introduced the keynote speaker, Haley Barbour (former Governor of Mississippi). Governor Barbour gave an excellent talk about the ways in which Mississippi's musical traditions have helped to improve race relations over the past century.
The meeting panels covered a broad array of topics, including:
- Ownership, Transfer and Trading of Intellecual Property Rights.
- The Cost of Truth, Can You Afford It?
- Artificial Intelligence, Machine Learning, and Algorithms: Studies in Law, Economics, and Racial Bias
- Thriving Post Pandemic - Private Practice and Expanding Regulatory Authority After COVID-19.
I joined Professors Todd Zywicki and Donald Kochan on a panel moderated by Judge Elihu Berle (Los Angeles Superior Court). The panel was entitled, Shareholder Wealth Maximization versus ESG and the Business Roundtable: The Growing Debate Over Corporate Purpose. I presented on the Securities and Exchange Commission's plans for a new mandatory climate-change-related disclosure regime. The prsentation drew from portions of a recent essay I coauthored with Professor George Mocsary, An Economic Climate Change?
The conference concluded with the tour of our new Civil Rights Museum in Jackson. It was a wonderful meeting, and I look forward to participating in future ABCBJ events!
Friday, November 12, 2021
According to SEC Chair, Gary Gensler, “[w]hen it comes to climate risk disclosures, investors are raising their hands and asking for more.” He has therefore asked his staff to prepare recommendations on new mandatory climate-change-related disclosure rules.
There appear to be two principal policy goals behind this proposed mandatory climate-related disclosure regime. First, to advise current and prospective investors of previously undisclosed physical and transitional climate-related risks through reliable, consistent, and comparable disclosures. Second, to structure the disclosure requirements to highlight “bad actors” and incentivize changes in the climate-related behavior of publicly traded companies.
Not everyone is, however, convinced that new, mandatory climate disclosures are necessary or even wise. For example, two of the five current SEC Commissioners have questioned the wisdom and/or need for new climate disclosure rules. In addition, Professor Stephen Bainbridge and Professors Paul and Julia Mahoney have expressed concern over the costs of a new climate-disclosure regime, as well as skepticism over the claim that climate disclosures are important to the average investor.
In our recent essay, An Economic Climate Change?, my coauthor George Mocsary and I weigh into the debate over the wisdom of new mandatory climate-change disclosure rules for issuers by asking: (1) Are the goals behind the proposed reforms worthy and appropriate for an SEC disclosure regime (the mission of which is to maintain efficient markets and facilitate capital formation)? (2) Can these goals be accomplished under the existing regime? (3) What would a new disclosure requirement cost, both directly and indirectly? (4) Would any benefits from increased disclosure outweigh those costs?
We conclude that, with respect to disclosure of transitional climate-related risks (risks to issuers from current or prospective regulatory demands and broader market trends toward a carbon-neutral world), new disclosure rules would be either redundant or outside the scope the SEC’s statutory authority.
Concerning mandatory disclosure of physical risk (a company’s risk to physical assets, markets, and supply chain due to climate-related extreme weather events), we express concern that the unreliability of the nascent discipline of “event attribution science” (which strives to identify causal links from human-influenced climate change to extreme weather events) would force issuers into rampant speculation that would be of little use to investors. It is not consistent with the SEC’s mission (and is likely outside its current statutory authority) to mandate disclosures that would be of little or no use to investors.
Finally, we conclude by highlighting the potential for some unintended consequences of mandatory disclosures in this area. For example, the burden of such disclosures may force some currently public companies to go private. This would have the result of further reducing the already decreasing number of investment opportunities for Main Street investors. Moreover, capital may shift abroad to markets that do not require climate-related disclosures, making U.S. markets less competitive. And perhaps most concerning, new climate disclosure rules may force larger, more eco-friendly companies to reduce their carbon footprint by selling off fossil-fuel-based assets and business lines. These assets may be purchased by private or foreign companies that are less concerned about the environment. This may actually result in a net increase in carbon emissions.
Friday, October 29, 2021
Mississippi College Invites Applications and Nominations for the Position of Dean of the School of Law
After serving many years as our amazing leader, Dean Patricia Bennett has announced that she is stepping down as Dean of MC Law at the end of this academic year (May 2021). Dean Bennett has been a great friend and mentor, and she has shepherded our law school with a steady hand through many challenges. She will be leaving the law school in a great position!
MC is beginning its search for our next dean now, and I encourage interested applicants to submit their materials for consideration. The following is a brief description of the desired characteristics of applicants and the responsibilities of the position (and here is a link to more complete information about the position and a how to apply):
The dean must enthusiastically embrace the university’s historic mission and possess the personal qualities to inspire the faculty, students, and alumni to advance the academic program and reputation of MC Law. The dean of MC Law provides the vision to sustain and lead the school to prominence in teaching, scholarship, and service. The dean is responsible for strategic leadership, academic excellence, and administration of MC Law. The successful candidate will be a thoughtful, entrepreneurial, creative, and collaborative leader who sees opportunity in the challenges facing legal education.
Candidates should demonstrate the capacity to lead a program of legal education, cultivate external funding, and in keeping with the mission of Mississippi College, be a committed Christian and a person of integrity.
Specific responsibilities are to ensure that the academic needs of students are met; recruit faculty, and recommend faculty appointments, reappointments, and promotions; and oversee curriculum development in shared governance with the faculty; support alumni relations, and cultivate external funding sources; construct and manage budgets for MC Law; see to the general administration of the law school; and interface effectively with the university, professionals in legal education, members of the bar and the state judiciary, and civic communities.
Friday, October 15, 2021
Can "hypermaterial" public information about a stock render the company's (once material) nonpublic internal data immaterial? Consider the following scenario involving social-media-driven trading in a meme stock:
XYZ Corporation’s stock price had been falling over the last month (from a high of $12 down to $10), due to a short-sale attack by a small group of hedge funds. In the past week, a group of individuals in a social media chatroom have attempted a now well-publicized short squeeze, motivated by a desire to punish what they view as predatory behavior by the hedge funds. As a result, the stock price has been driven up to $300, significantly above where the stock was trading before the short-sale attack. The company's nonpublic data (earnings, etc.) that will be reported next week reflects the "true" price of the company's shares should be $8. With knowledge of the above public and nonpblic information, XYZ and some of its insiders issue/sell XYZ shares.
Has XYZ and its insiders committed insider trading in violation of the antifraud provisions of Section 10(b) of the Securities Exchange Act?
Insider trading liability arises under the classical theory when the issuer, its employee, or an affiliate seeks to benefit from trading (or tipping others who trade) that firm’s shares based on material nonpublic information. In such cases, the insider (or constructive insider) violates a fiduciary or other similar duty of trust and confidence by failing to disclose the information to the firm’s shareholder (or prospective shareholder) on the other side of the trade.
In Basic Inc. v. Levinson, 485 U.S. 224, 231-2 (1988), the Supreme Court has held that information is “material” for purposes of insider trading liability if “there is a substantial likelihood that a reasonable shareholder would consider it important” in making an investment decision, and there is a “substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”
Prior to the onset of the social-media-driven trading, I think it's pretty clear that the insiders' nonpublic information that the company's stock (currently trading at $10) is actually worth $8 is material. In other words, there is a substantial likelihood that a reasonable shareholder would consider important information that a stock trading at $10 is actually worth $8. But is that same information still material after the social-media-driven trading has pushed the stock's price to $300?
In our forthcoming article, Expressive Trading, Hypermateriality, and Insider Trading, my coauthors Jeremy Kidd, George A. Mocsary, and I argue that once material nonpublic internal data can be drowned out (and be rendered immaterial) by subsequent hypermaterial public information like a dramatic price movement resulting from a well-publicized social-media-driven run on a stock.
If the issuer's and insiders' nonpublic information about the firm is immaterial, then they may trade while in possession of it without violating the anti-fraud provisions of the federal securities laws. We welcome your comments! Here's the abstract:
The phenomenon of social-media-driven trading (SMD trading) entered the public consciousness earlier this year when GameStop’s stock price was driven up two orders of magnitude by a “hivemind” of individual investors coordinating their actions via social media. Some believe that GameStop’s price is artificially high and is destined to fall. Yet the stock prices of GameStop and other prominent SMD trading targets like AMC Entertainment continue to remain well above historical levels.
Much recent SMD trading is driven by profit motives. But a meaningful part of the rise has been a result of expressive trading—a subset of SMD trading—in which investors buy or sell for non-profit-seeking reasons like social or political activism, or for aesthetic reasons like a nostalgia play. To date, expressive trading has only benefited issuers by raising their stock prices. There is nothing, however, to prevent these traders from employing similar methods for driving a target’s stock price down (e.g., to influence or extort certain behaviors from issuers).
At least for now, stock prices raised by SMD trading have been sticky and appear at least moderately sustainable. The expressive aspect, which unites the traders under a common banner, is likely a reason that dramatic price increases resulting from profit-seeking SMD trading have persisted. Without a nonfinancial motivation to hold the group together, its members would be expected to defect and take profits.
Given that SMD trading appears to be more than a passing fad, issuers and their compliance departments ought to be prepared to respond when targeted by SMD trading. A question that might arise is whether and when SMD-trading-targeted issuers, and their insiders, may trade in their firms’ shares without running afoul of insider trading laws.
This Article proceeds as follows: Part I summarizes the current state of insider trading law, with special focus on the elements of materiality and publicity. Part II opens with a brief summary of the filing, disclosure, and other (non-insider-trading-related) requirements issuers and their insiders may face when trading in their own company’s shares under any circumstance. The remainder of this Part analyzes the insider trading-related legal implications of three different scenarios in which issuers and their insiders trade in their own company’s shares in response to SMD trading. The analysis reveals that although the issuer’s and insiders’ nonpublic internal information may be material (and therefore preclude their legal trading) prior to and just after the onset of third-party SMD trading in the company’s stock, subsequent SMD price changes (if sufficiently dramatic) may diminish the importance of the company’s nonpublic information, rendering it immaterial. If the issuer’s and insiders’ nonpublic information about the firm is immaterial, then they may trade while in possession of it without violating the anti-fraud provisions of the federal securities laws.
Friday, October 1, 2021
Insider trading reform has been a consistent theme in my last few posts (see, e.g., here, here, here, and here). In keeping with this theme, I’d like to highlight a new article, How Creepy Concepts Undermine Effective Insider Trading Reform, which was posted just yesterday by Professor Kevin R. Douglas (Michigan State College of Law). Professor Douglas is an important new voice in the areas of securities regulation, corporate finance, and business law more generally. Here’s the abstract:
Lawmakers are building momentum towards codifying our insider trading laws to clarify which kind of trading is illegal. In May 2021, the US House of Representatives passed the Insider Trading Prohibition Act for the second time in two years. In January 2020, a Securities and Exchange Commission sponsored task force on insider trading released a report containing proposed legislation. Both the House Bill and the task force proposal would prohibit trading while in possession of “wrongfully obtained” information and prohibit trades that involve a “wrongful use” of information. This article explains why the concept of “wrongful” trading is too ambiguous to improve insider trading law and explores the requirements of effective legislative reform.
For decades, scholars have described insider trading doctrine as mystifying and called for reform. Many explain the confusion by pointing to the stark difference in how enforcement officials and federal courts apply insider trading law. Others argue that the confusion is caused by policymakers failing to choose between fostering efficient markets and fostering fair or equitable markets. This article argues that the conflict between courts and enforcement officials is a symptom of two deeper conceptual problems—one at the doctrinal level and one at the policy level. The doctrinal confusion is more precisely caused by the attempt to simultaneously invoke two conflicting concepts of “fairness.” Fairness meaning consensual transactions, versus fairness meaning transactions in which all parties enjoy equal access to all material information and other economic values. Attempting to simultaneously apply these mutually exclusive notions of fairness has caused a slow and inconsistent conceptual creep, resulting in an incoherent doctrine.
The policy confusion is caused by officials relying on economic models that use misidentified theories of “economic efficiency.” Officials describe the policy goal of our insider trading regime as encouraging capital formation in US securities markets and economic growth in general. These goals imply an exclusive commitment to promoting “allocational efficiency”—or maximizing wealth. However, scholars usually rely on the concept of “market efficiency” when evaluating the law and practice of insider trading. The definition of market efficiency relies on assumptions that embody an unacknowledged focus on economic distribution—equalizing wealth. This includes the assumptions that all investors (1) trade at the same price (the correct price) and (2) have equal access to all available information. Conflating these forms of efficiency causes officials to unintentionally oscillate between promoting opaque distribution goals and promoting economic growth.
This article recommends clarifying insider trading law by prioritizing one of the two conflicting fairness doctrines and a compatible policy goal. Clarity requires specifying whether consent is a defense against insider trading liability. Enforcing only one fairness doctrine gives everyone the option of attempting to privately adhere to both principles while successfully applying one of the principles through law.