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 to establish a prohibition on insider trading. Today, most legal systems have followed its 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. However, 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 shows the efforts of the courts 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 in the Market

Initially, the Court of Appeals for the Second Circuit established the “Equal Access Theory” in 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 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 gathering information and predicting future results. It is unreal to expect that the individual investor, solely relying on public information, can possibly access the same data as the sophisticated broker.

Approaching Reality, Inequality in the Markets

The Supreme Court overruled the findings of the Second Circuit 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 on 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 in its reasoning seventeen years 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”). The Court also stated 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 on using confidential information to trade in stocks without the acquiescence of the owner. However, as a consequence of 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 for 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 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.

Certainly, it does not look good for the Supreme Court to protect this kind of behavior, at least publicly. The Court probably did not intend to make a statement that could be interpreted in this manner. Such approach goes against the very purpose of rule 10 (b) of the SEA to “insure honest securities markets and thereby promote investors confidence,” which guided the decision in 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 against a defendant who 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

If the Supreme Court acknowledges that the market is not level 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 does not seem likely that this will happen. The idea of a capital market that provides equal opportunities and 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 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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Hi Francisco,

Just a few things I'm thinking about after the first few reads of your paper. I don't know much about securities law but did do some reading about it...anyway, first, you say that securities law is attempting to achieve the unachievable in prohibiting insider trading. On a general note, the government tries to work towards many ideals we don't think are perfectly achievable in practice (I'm thinking about equal opportunities in society for people of all races, or equal access to public school education, for example). Second, what are exactly you trying to argue here? That insider trading should no longer be prohibited? Or that the Supreme Court's opinions have simply been contradictory? (That said, I think you can make the case that insider trading should be abolished if you want to.)

Hi Jessica, my answers to your comments are the following:

1. Of course that there are many issues that are regulated by the government that are very difficult to achieve, but one thing is to improve regulations to attain a specific purpose, no matter how difficult it may be, and another is to give legal arguments that do not make sense in order to cover a truth. Maybe it is impossible to achieve perfect access to education or equal opportunities, but these are issues that can be improved through proper regulations and policies. On the other hand, the capital markets are designed based on differences among investors. As mentioned in my paper, if all investors put their money in the same stocks and trade in the same direction, the market would not work because there would be not enough liquidity (provided by people who trade in the opposite direction). Therefore, capital markets are designed based on differences among investors, provided, among other aspects, in their access to information. Giving legal arguments to cover this is just transcendental nonsense.

2. Related with the first point, what I am arguing is that the justifications provided by courts to abolish insider trading are contradictory and don't make sense. Of course that you can make a strong case defending that insider trading should be abolished, but it should be based on good reasoning and coherent ideas and not just in false beliefs. If equality in the markets cannot be an argument to adopt a prohibition, as explained before, maybe the argument could be based in property rights over the information, but again, courts should face the consequences of such argument. The main consequence would be that the owner of material confidential information could dispose from it and other people then would have a right to use such information and trade lawfully with informational advantages. The problem is that such idea reveals the truth about the markets, that they are not “fair” or provide equal opportunities.

By saying this I am not making an attack against capital markets. I am just stating how things are, which is the purpose of my paper.

Also, I think there are a few more legitimate motivations for banning insider trading and I think you should refute them more forcefully (rather than saying they're wrong because the Supreme Court hasn't always referenced each or listed them in an opinion).

In my paper I am not favoring or attacking the prohibition on insider trading per se. It is debatable whether insider trading should be allowed and there are arguments favoring both sides. In any case, if you read the links on the paper you will realize that the main arguments favoring the prohibition are based basically in ideas of fairness and equal access to information, which I don’t consider strong enough because of the reasons already mentioned.

The whole reason these laws were made, as I understand, was that in the 1930s people thought that the entire system was unfair. The 1933 act was an attempt to restore integrity to the stock market - which after the 1929 crash came to be viewed as a place that was routinely exploited by people with an edge. The whole country suffers as a result if it becomes harder to sell pieces of your business to the general public if they think the game is rigged. Arguably it's good for the whole country if someone can quickly raise capital if they have a good idea and want to spread it. People are more willing to invest in your business if they think there's going to be a liquid market for selling the shares they buy.

First, notwithstanding all the insider trading regulations that exist today, as opposed to 1929, I don’t think that it is possible to state that the market woks better and that the game is not rigged (think in the Goldman Sachs case, Enron, etc. that although are not based on insider trading, the basic issue is fraud on the market by people with advantages in it). Additionally, there are many scholars explaining that insider trading does provide liquidity and, moreover, that regulations on the subject do not really change the behavior of investors nor the performing of the markets.

I understand that once people invest money in the market, they are as you say, "on their own." However, our society allows - and enables - people to specialize in all sorts of things. While your average trader hypothetically shouldn't have nonpublic information about a company, he may have some fancy computer technique to analyze markets that you or I may not. By the same token, and I hope this isn't too much of a stretch, we are now gaining the tools to analyze legal problems by virtue of our enrolling at Columbia Law School. I guess you could say this is unfair to the rest of people with legal problems in another manner.

I am not sure if I understood the first example with the relation to the legal education in Columbia. However, this is the whole point, there are people with more advantages than others and the capital market is one of the main places in which those advantages come into play. The Supreme Court had to recognize this in Chiarella and any further statement in the contrary has not been able to be sustained. -- JessicaCohen