I Know Something You Don’t Know: Insider Trading

-- By FranciscoGuzman - 11 Apr 2010

The Origins of the Ban

The United States was the first country to begin aggressively ferreting out insider trading, and many others have followed its example. Each country’s laws were enacted with goal of forbidding individuals to trade on securities based on non-public information. In general, Americans are loath to the idea that some traders are afforded informational advantages that are unavailable to the rest of the market. However, U.S. courts have been unable to ground this feeling of injustice in consistent, coherent holdings.

Equality in the Market

In 1961, the SEC's chairman and Columbia Law professor William Cary first articulated the "disclose and abstain rule," and argued that Rule 10 b-5 of the 1934 Securities Act (mail fraud) could be enforced through the prosecution of insider trading. Seven years later, the Court of Appeals for the Second Circuit shared a similar "Equal Access Theory" of trading in S.E.C. vs. Texas Gulf Sulphur Co. According to the Court, the enforcement of rule 10 b-5 is based upon the idea that investors trading on impersonal exchanges should have relatively equal access to material information.” The Court explained that protecting a level playing field for investors increases their confidence in themarkets. Put another way, in order to guarantee the survival of the market, it was (and is) essential to incentivize individuals and corporations to invest their resources in it.

Because the design of capital markets is based on the inequality of individuals, securities markets - in the end - are used unequally among investors. Contrary to the reasoning in Texas Gulf, if all investors had the same information, they would invest in the same securities – making it impossible for individuals to be profitable.

However, our insider trading laws seem to conflate one type of “insider” information with another – i.e. analyzed information. While our insider trading laws attempt to make relevant information available to all, only some investors have the tools with which to analyze it. Our securities markets are dominated by individuals whose professional lives consist of gathering information and predicting future results. The individual investor, solely relying on public information, cannot possibly access the same data as the sophisticated broker. This distinction should be considered by the courts. After all, if it is the creed of capital markets they wish to defend, those who invest their time and resources in it should be rewarded.

Approaching Reality, Inequality in the Markets

The Supreme Court felt that the SEC had been overstepped its bounds in its vigorous enforcement of Rule 10 b-5. It overruled S.E.C. vs. Texas Gulf Sulphur Co. more than twelve years later, holding that “neither the Congress, nor the [SEC] ever has adopted a parity-of-information rule.” Chiarella v. United States. According to the Supreme Court, the ban was necessary to punish insider traders because they had breached their fiduciary duty to the corporation and its shareholders. Seventeen years later, in United States v. O’Hagan, the Court extended fiduciary theory to outsiders by contending that insider trading liability was based on the misappropriation of confidential information with fraud to the source. The Court also claimed that the corporation’s confidential information “qualifies as property to which the company has a right of exclusive use.”

Property rights may justify a prohibition on using confidential information to trade in stocks without the agreement of their owner. However, if courts were to follow this approach, it would be legally permitted to use such information with the consent of the owner. According to the Court “if the fiduciary discloses to the source that he plans to trade on the nonpublic information, there is no deception and thus no § 10 (b) violation.”

The Supreme Court’s reasoning not only acknowledges that capital markets are based on inequality among investors, but also encourages the enrichment of some individuals at the expense of others. Theoretically, anyone could use inside information, as long as there is no fraud to the source. Such fraud can be avoided with the authorization of the source or simply by the disclosure of the fiduciary’s intentions. The Court probably did not intend to make a statement that could be interpreted in this manner. This approach goes against the very purpose of rule 10 (b) of the SEA: to “insure honest securities markets and thereby promote investors confidence,&#8221.

Further Developments

Subsequent case law has discussed the aforementioned situation. In SEC v. Rocklage the First Circuit had to recognize the inconsistencies of the Supreme Court’s reasoning in O’Hagan. The court refused to dismiss a complaint against a defendant who had disclosed to the source of the information that she had intended to communicate it to a third party. The decision in Rocklage again relied on the idea of fairness to “promote investors confidence” in the market.

Reconciling the Decisions

If the Supreme Court acknowledges that the market does not provide the same opportunities to all and protects the property over material non-public information, it should allow corporations to use such information at their will. This use may include permitting executives to trade securities based on it.

However, it seems unlikely that this will happen. The idea of a capital market that provides equal opportunities and protects investors is too attractive to baldly admit its falseness. Nevertheless, the legal arguments provided to ban insider trading are far from clear or logical, being a perfect example of transcendental nonsense. Once again, law is following politics, as capital markets are too well entrenched in our society to recognize that once people invest their money in it, they are on their own.

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