I KNOW SOMETHING THAT YOU DON’T: INSIDER TRADING

-- By FranciscoGuzman - 11 Apr 2010

THE ORIGINS OF THE BAN

The United States was the first country that adopted a prohibition on insider trading. Today, most legal systems have followed the example seeking to “strengthen their capital markets”. The common principle is that law should forbid individuals to trade on securities based on non-public information. It does not seem right that some people use informational advantages that are unavailable to the rest of the market. The problem is that it is unclear which are the fundaments and purpose of the prohibition. This situation is particularly evident in the U.S. as demonstrated by the case law dealing with the issue. The following analysis demonstrates the efforts of the Supreme Court to protect an ideal that it is unachievable: a securities market that provides equal opportunities to all individuals. Apparently, this is another case of contradictory reasoning defending the creed of capital markets.

EQUALITY ON THE MARKET

Initially, the Supreme Court of the United States established the “equal access theory” (SEC v Texas Gulf Sulphur Co.). According to the Court, rule 10 b-5 of the SEC “is based in policy on the justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information.” The reasoning was that capital markets are supposed to provide a level field for investors, increasing their confidence on it. The political purpose of such statement is obvious, in order to guarantee the survival of the market it is essential to encourage individuals and corporations to invest their resources on it.

The inaccuracy of the idea that securities markets provide a symmetrical access to information is self evident. The design of capital markets is based on the inequality of individuals. If all investors had the same information, markets would not work. In such scenario, everybody would invest in the same securities and it would be impossible to make profits. A proof of this is that there are many professionals dedicated solely to gather information and to predict future results. It is unreal to expect that the individual investor, solely relying on public information, can have access to the same data that the sophisticated broker.

APPROACHING TO REALITY, INEQUALITY ON THE MARKETS

The Supreme Court acknowledged the above and reversed its findings 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). The reason to prohibit insider trading now was the breach of a fiduciary duty to the corporation and its shareholders incurred by insiders who traded securities based on material non-public information. (“Fiduciary Duty Theory”) As this rule did not reach outsiders of a corporation, the Supreme Court had to go further on its reasoning seventeen year later. In United States v. O’Hagan, the Court held that insider trading liability was based on the misappropriation of confidential information with fraud to the source (“Misappropriation Theory”). In O’Hagan, the Court held that the corporation’s confidential information “qualifies as property to which the company has a right of exclusive use.”

Arguably, property rights may justify a prohibition to use confidential information to trade on stock without the acquiescence of the owner. However, as a consequence to 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 ‘deceptive device’ and thus no § 10 (b) violation.” Unfortunately, the Court did not provide further explanations, leaving the door open to lower courts to future interpretations.

The evolution of the Supreme Court’s reasoning not only acknowledges that capital markets are based on inequality among investors, but also is encouraging enrichments of some people 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 by the authorization of the source or simply by the disclosure of the fiduciary’s intentions.

Certainly it does not look good for the Supreme Court to protect this kind of behavior, at least publicly. Such approach goes against the very purpose of rule 10 b of the SEA to “insure honest securities markets and thereby promote investors confidence.” (O’Hagan)

FURTHER DEVELOPMENTS, BACK TO BASICS

Subsequent case law has faced 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 in a case where the defendant had disclosed to the source of the information her purposes to communicate it to a third party who traded based on it. The decision in Rocklage, again relied on the idea of fairness to “promote investors confidence” in the market.

RECONCILING THE DECISIONS

However, it does not seem likely that this will happen. The idea of a capital market providing equal opportunities and that protects investors is too attractive to simply 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 the capital market is too well entrenched in our society to recognize that once people invest their money on it, they are on their own.

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