Insider Trading: A Clash Between Law and Economics
- Stephen F. DiamondStephen F. DiamondSchool of Law, Santa Clara University
Insider trading is not widely understood. Insiders of corporations can, in fact, buy and sell shares of those corporations. But, over time, Congress, the courts and the Securities and Exchange Commission (SEC) have imposed significant limits on such trading. The limits are not always clearly marked and the principles underlying them not always consistent. The core principle is that it is illegal to trade if one is in the possession of material, nonpublic information. But the rationality of this principle has been challenged by successive generations of law and economics scholars, most notably Manne, Easterbrook, Epstein, and Bainbridge. Their “economic” analysis of this contested area of the law provides, arguably, at least a more consistent basis upon which to decide when trades by insiders should, in fact, be disallowed. A return to genuine “first principles” generated by the nature of capitalism, however, allows for more powerful insights into the phenomenon and could lead to more effective regulation.
Insider trading has long been a problematic concept. In the popular imagination, it is the theft of information by corporate executives who take advantage of their privileged positions to profit personally by timely purchases or sales of their own company’s securities. While that is, indeed, one form of insider trading, and it can be illegal, the concept has taken on much broader dimensions. Not all trades in stock by insiders are illegal, and some trades by “outsiders” are now viewed by regulators and the courts as forms of illegal “insider” trading. In addition, over the past decade or more, regulators, particularly in the United States, have tried to push out the boundaries of illegal insider trading to include ever wider networks of individuals who come into possession of material nonpublic information. This has led to a series of significant court decisions that are redrawing the map in this area. Altogether, these developments make insider trading a difficult to concept to theorize and, therefore, a challenge for empirical researchers who are interested in exploring the area.
The article starts with “Insider Trading Law in the United States,” an overview of the evolution, from a legal standpoint, of the concept of insider trading. This is important so that researchers understand the terms as they are used by real-world practitioners and policymakers. Then, three sections summarize the scholarly debate about insider trading that began with the seminal work of the late Henry Manne (1966) and has been continued into the early 21st century by both legal scholars and economists: “The ‘Law and Economics’ Counter-Attack,” “The ‘Property Rights’ Alternative,” and “The Limits of the Property Rights Approach” (see Bainbridge, 2013b, for an overview of modern research efforts). Finally, the section “Open Questions” is an exploration of the new terrain of insider trading research, including the impact of high-frequency trading and so-called government insider trading.
Insider Trading Law in the United States
The primary policy concern that motivates the regulation of trading by insiders (whether buying or selling) is the potential for an information asymmetry to exist between an insider and a counter-party in the transaction. Inevitably, an insider will have more information about the fundamentals of a business than an outsider. This concern was first clearly expressed in 1932 by Berle and Means (1991) and later absorbed, in part, by the agency theory school (see the article “Agency Theory in Business and Management Research”; see also Alchian & Demsetz, 1972; Jensen & Meckling, 1976). The core potential problem is generated by the rise of the large publicly traded corporation. In such firms, power is typically concentrated in a group of controlling shareholders who have access and influence over those insiders at the board and officer level who manage the day-to-day operations of the firm. At the same time, the firm relies on financing from a widely dispersed base of non-controlling shareholders who lack that same privileged access (Diamond, 2019; Pitelis, 1987).
In the United States, federal and state securities laws are intended, in part, to “level the playing field” among buyers and sellers by mandating disclosure of material information about firms and their securities, as well as prohibiting fraud in securities transactions. Arguably, inaccurate or incomplete information can undermine the integrity of the market, causing potential buyers to discount prices they are willing to pay and, in turn, causing sellers of high-quality goods (in this case, securities) to withdraw.1 In the eyes of the SEC (2014), the federal agency charged by Congress with oversight responsibility for the stock market, insider trading “undermine[s] the level playing field that is fundamental to the integrity and fair functioning of the capital markets.” This is an expression of concern about the potential for a classic “lemons” problem, first comprehensively explained by Akerlof (1970). In the actual daily trading of shares, the problem is expressed in the bid–ask spread set by market makers. The spread is the difference between the price a market maker is willing to buy (sell) a share for as opposed to the price she is willing to sell (buy) it for. The spread serves, in part, as compensation for assuming the risk of adverse selection, i.e., that the market maker is dealing with a seller (buyer) with inside information (Diamond & Kuan, 2018; Glosten & Milgrom, 1985; Huang & Stoll, 1997).
The U.S. securities laws do not, however, expressly outlaw insider trading.2 Instead, through case law, courts have fashioned the modern prohibition on insider trading based on the broad anti-fraud language in the Securities Exchange Act of 1934, as amended (the “Exchange Act” or “1934 Act”). The strongest view of insider trading to come out of the federal courts argued for an absolute “disclose or abstain” approach3 to achieve what the Second Circuit Court of Appeals in the seminal modern insider trading case, SEC v. Texas Gulf Sulphur Co. (1968), called “relatively equal access” to material information among all market participants.4 This is the most practical starting point for understanding the obligations of someone in possession of material nonpublic information about a company’s securities, particularly employees or other potential insiders. If one party (typically, but not always, an “insider”) is in possession of material nonpublic information it is important for that party to stop before trading and ask whether they have an obligation here to “disclose or abstain.” If so, that party must either provide the potential counter-party with the same material information that the first party has about the issuer, or else abstain entirely from entering into the transaction.
It is perfectly permissible, of course, for insiders to buy or sell the securities of the company of which they are considered insiders if there is in fact a level playing field between the insider and the counter-party on the other side of the transaction. Even if there is not equal access to the same information, absent a fiduciary duty, an insider may also be able to trade.5 Thus, insider trading is not per se illegal.
The 1934 Act was passed in the wake of the stock market crash of 1929 during a period when it was widely believed that those “in the know” had benefitted at the expense of the wider investing public through a variety of manipulative investment practices. A U.S. Senate (1934) investigation was concerned about this issue, stating in an oft-cited passage:
Among the most vicious practices unearthed at the hearings. . . was the flagrant betrayal of their fiduciary duties by directors and officers of corporations who used their positions of trust and the confidential information which came to them in such positions, to aid them in their market activities. Closely allied to this type of abuse was the unscrupulous employment of inside information by large stockholders. (p. 55)
Thus, Section 10(b) of the 1934 Act, as passed into law by the Congress, states:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange—. . .
b. To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered. . . , any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.
The SEC followed the passage of the 1934 Act by using its Congressionally granted rule making power to promulgate Rule 10b-5 in 1942. Rule 10b- 5 makes it unlawful “in connection with the purchase or sale of any security”:
To employ any device, scheme, or artifice to defraud,
To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.
Although the “level playing field” approach offers the appearance of simplicity and clarity, it was viewed as too sweeping in its application by some critics, particularly among conservative legal scholars who were gaining ground by the early 1970s. By the end of that decade, the insider trading prohibition was grounded on a much narrower basis than that mandated by a simple “disclose or abstain” rule. In most instances, only where the insider owes a fiduciary duty to a less well-informed counter-party with respect to the information about the securities that they intend to trade would a purchase or sale to that counter-party be prohibited by law. The courts had originally begun to recognize this duty, at least in a limited fashion, well before federal securities laws were in place. As early as its 1909 opinion in Strong v. Repide, the U.S. Supreme Court held that even though a director may not be under a fiduciary duty to disclose to a shareholder their knowledge affecting the value of the shares, a disclosure obligation might exist in special cases. This declaration of a “special circumstances” test began the process of dissolving the prevailing older majority rule that corporate directors and officers were free to take advantage of their inside knowledge when dealing with corporate shareholders. Thus, prior to the statutory effort by Congress, the use of a fiduciary constraint was actually an instance of the courts intruding on the insider prerogative to trade their own shares thereby taking advantage of their current or future shareholders.
But when the SEC used that new statutory foundation to widen its net with an aggressive reading of the mandate of the 1934 Act, a more conservative judiciary, led by Supreme Court Justice Lewis F. Powell, looked back to that fiduciary approach to cut the Commission down to size. In his majority opinions in Chiarella v. U.S. (1980) and Dirks v. SEC (1983), Justice Powell undertook a “substantial narrowing of the insider trading prohibition” (Bainbridge, 2013a, p. 83). Powell’s approach became known as the “classical theory” of insider trading (Gubler, 2017). This theory ensnared “permanent insiders,” as well as those who “temporarily become fiduciaries of the corporation” such as “attorneys, accountants and consultants” (United States v. O’Hagan, 521 U.S. 642 (1997)). But the net did not extend beyond the corporate structure to include, as the SEC argued it should, so-called “outside” traders who “misappropriated” information in violation of a fiduciary obligation to a principal other than that corporation. Chief Justice Burger supported such an expansion in his dissenting opinion in Chiarella but was not able to prevail on a majority of the Court despite some support from Justices Brennan and Stevens (Easterbrook, 1981).
In theory, the prohibition applies not only to actual insiders but also to persons who have been tipped off by those insiders. This is known as “tipper–tippee liability.” The extension of liability to encompass the tipper–tippee ploy closed a potential loophole that might have allowed insiders to pass on information to a friendly third party to trade, thus avoiding direct liability. As the Court held in Dirks v. SEC, there are two elements that must be met to impose liability on the tipper: (1) he or she must have had a duty that was violated by the disclosure of insider information to the tippee; and (2) he or she must have received some form of “personal benefit” from the disclosure.6 Tippee liability is predicated on the existence of the tipper’s duty as well as awareness by the tippee that the duty was breached.
The Galleon hedge fund scandal that erupted in 2009 (see article “Finance Crime”; also Merced, 2009) involved dozens of examples of tipper–tippee liability and demonstrated the aggressive posture the SEC has been able to take towards this form of insider trading in the wake of Dirks. Galleon was a multi-billion dollar hedge fund based in New York and led by Raj Rajaratnam. Rajaratnam and his team had built up a wide network of well-placed sources of information about public companies in New York and Silicon Valley. Among the more notorious examples of the tips that the Galleon scheme exploited was a call from Rajat Gupta, a member of the board of directors of Goldman, Sachs and Co., the leading Wall Street investment bank, to Rajaratnam in the wake of a Goldman board meeting. Gupta told Rajaratnam that the bank was about to receive a significant investment from Warren Buffet, and he provided details about the bank’s still private financial results. Rajaratnam, in turn, acted on the tip “caus[ing] the various Galleon hedge funds that he managed to trade on the basis of material nonpublic information, generating illicit profits and loss avoidance of more than $23 million.” (SEC Complaint, 2011, p. 2). This was a classic form of tipper–tippee insider trading. The U.S. Department of Justice and the SEC secured 85 convictions linked to Galleon when the dust finally had settled. Both Rajaratnam and Gupta were sent to federal prison for their involvement in the complex and long-lasting scheme. Senior executives at Intel, IBM, and McKinsey & Co. were also convicted in the scheme, which, overall, generated more than 90 million dollars in illegal profits from trades involving Google, Hilton Hotels, AMD, Sun Microsystems, and Intel, among others (SEC, 2011).
In response to these renewed enforcement efforts by the SEC and the Department of Justice, there was some effort by circuit courts, in the mold of the late Justice Powell, to restrain the federal government. In 2014, the Second Circuit Court of Appeals, based in New York, issued a decision that was called by a leading defense lawyer who had once been an SEC attorney, “a well-deserved generational setback for the Government” (Eisenberg, 2015). The fiduciary duty cases had held that a breach of that duty could only be found if the tipper will achieve “some personal gain” or “benefit” as a result of the disclosure of the information used as a basis for the trade. Of course, the vagueness of this concept of “personal benefit” was readily apparent. Did this mean some form of financial gain only, or could this also mean resting liability on an almost inexhaustible, and therefore perhaps unknowable, list of possible “non-pecuniary benefits”? Exploiting that lack of clarity, the Court of Appeals imposed a new challenging requirement that the tippee must not only know that she is using confidential information as a basis for her trading but also know that the information was disclosed to her “in exchange for a personal benefit” to the insider.
Had this decision prevailed, it would have been an “impossible hurdle for the Government in many cases” (Eisenberg, 2015). But it did not stand for long. In 2016, the Supreme Court in Salman v. United States expressly rejected the Newman holding “to the extent the Second Circuit held that the tipper must also receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family or friends. . .” (Emphasis added; citations omitted). Instead, a familial or other close relationship with the tipper was sufficient to support a finding of a personal benefit to the tipper. The Court relied on its previous holding in Dirks which “makes clear that a tipper breaches a fiduciary duty by making a gift of confidential information to ‘a trading relative,’ and that rule is sufficient to resolve the case at hand.”
In the wake of Justice Powell’s retirement from the bench in 1987, the SEC eventually also had success with the “misappropriation theory” Powell had brushed aside in Chiarella. In the wake of the Court’s decision in United States v. O’Hagan in 1997, no one could legally trade securities while in possession of material nonpublic information if they obtained that information in breach of a fiduciary obligation, either to the corporation whose securities are at issue (the “classical theory”) or to the original third party source of the information (the “misappropriation theory”). In that case, a lawyer working at a law firm representing the acquirer of a target company bought securities in the target before the takeover announcement. By trading with the stockholders of the target firm, rather than with those of his own firm’s client, he was not in breach of any fiduciary obligation to those stockholders. But the Court nevertheless held that the lawyer violated Section 10(b) and Rule 10b-5 “when he misappropriate[d] confidential information for securities trading purposes, in breach of a duty owed to the source of the information” (p. 652) (emphasis added), namely his own law firm and its client, the acquiring firm.
Thus, the misappropriation theory expanded the classical theory of insider trading to include a ban on trading by outsiders who trade on “confidential information that will affect the corporation’s security price when revealed, but who owe no fiduciary or other duty to that corporation’s shareholders” (p. 653). As Justice Ruth Bader Ginsburg, writing for the majority, stated in O’Hagan:
Under the. . . “classical theory” of insider trading liability, [the securities laws are] violated when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information. . . . The “misappropriation theory” holds that a person commits fraud. . . when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. . . .Under this theory, a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information. . . . The two theories are complementary, each addressing efforts to capitalize on nonpublic information through the purchase or sale of securities. (pp. 651–652)
Nagy (2009) has raised a concern that this trilogy of cases—Chiarella, Dirks and O’Hagan—“stretched” (p. 1339) the application of a fiduciary duty inappropriately in order to accomplish a policy goal seen as “desirable” (p. 1340) by the Supreme Court. The Court has, she maintains, created a “fiduciary fiction” (p. 1337) free of the constraints of a more traditional reading of the common law origins of the fiduciary obligation. This “may well have emboldened” (p. 1340) lower courts to open the door to holding certain kinds of insider trading illegal even where the link to such a duty is tenuous at best. Bainbridge (2013a) echoed her concern noting that the effect may be to return the regulatory framework to the more expansive “disclose or abstain” position of the SEC.
The “Law and Economics” Counter-Attack
Henry Manne, a pioneering scholar of law and economics (Manne, 1966, and see article “Law, Economics, and Courts”), triggered a widespread and controversial debate about insider trading when he challenged the SEC’s decision in the early 1960s to regulate the practice more aggressively (Bainbridge, 2009). Manne brought a level of analytical rigor to legal scholarship that had long been missing but did so from an ideological perspective strongly influenced by the free market ideology of Friedrich Hayek and others. It was inevitable that his views would spark a harsh reaction from the established securities law world, including many academics and policymakers, for whom the need of robust government oversight of the securities markets had been taken as a given ever since the collapse of those markets in 1929.
Most controversially, Manne proposed that trading by corporate insiders be deregulated. He argued it was a valid form of executive compensation and that such trading would contribute to market efficiency. The former argument was widely criticized (Bainbridge, 2002; Clark, 1986; Easterbrook, 1981), even by fellow free market advocates, which Manne (2005) gracefully acknowledged in later work on the issue. Calls for allowing insider trading as a form of compensation are now heard only on the right-wing fringes of academic debate (Boudreaux, 2009). Nonetheless, that proposal did stimulate the eventual emergence of the quite useful view that information is a “property right” belonging to the firm, which I discuss more thoroughly below in “The ‘Property Rights’ Alternative.”
Manne’s view that market efficiency would improve if insider trading were unregulated had greater salience. Clearly that kind of trading could lead to price impact. As indicated by the Galleon scandal, insiders who now trade, illegally, on material nonpublic information do profit by their trades (until and unless they are caught by regulators or the Department of Justice, of course). That indicates that undisclosed insider information has value and is not normally reflected in the market price the public pays for stock. The question remains, however, to whom should be awarded the right to exclude others from the use of that information, i.e., a property right in it.
In addition, as explained at the outset, stock exchange market makers charge a fee in the form of a wider bid–ask spread due to concern that they may be trading with “informed” traders, sometimes referred to as the “adverse selection” component of the spread (Bagehot, 1971; Copeland & Galai, 1983; Diamond and Kuan, 2018; Glosten & Milgrom, 1985). This fact indicates that these experienced market professionals recognize that material inside information may have leaked out that is not yet known to the wider market and, more importantly, to them. If insiders were allowed to trade freely on nonpublic information, on the other hand, they would likely sell when they had negative information and buy when they had positive information. Those price changes would reflect greater understanding about the actual value of the firm. Although he does not quite acknowledge it, this process lies at the heart of Manne’s argument that insider trading improves market efficiency (Manne, 2005). Of course, as Manne admitted, short-term “swing” traders across from an informed insider might lose money on that particular trade, but long-term holders would be able to ride along as prices adjusted in reaction to the insider trades with the confidence a firm’s share price was closer to the firm’s value.
Opening a wider door to trading by informed insiders, then, arguably brings more information about a stock to the market and thus could lead to a more rational allocation of capital. Nonetheless, serious criticism of the efficiency prong of Manne’s contribution has also been made. Haft (1982; see also Dent, 2013) argued that if trading by corporate insiders on nonpublic information were allowed “this rule would likely impair corporate decision-making at all hierarchical levels. Subordinates would stall the upward flow of critical information to maximize their opportunities for financial gain” (pp. 1054–1055). Regulating the internal distribution of trading rights would be inordinately complex and likely to make management of employee morale very challenging. Levmore (1982) made the point that “an insider can profit from a decrease in the firm’s stock price as well as an increase; the temptation of profit might actually encourage an insider to act against the corporation’s interest” (p. 149). It is not at all clear, then, that the legalization of insider trading would lead to greater market efficiency. Advocates of the idea have paid little or no attention to the process whereby that information would actually be incorporated into stock prices. Nor are they persuasive in claiming that some increased role for private ordering would be any better at striking the right balance than an attentive and well-resourced regulatory agency overseen by an independent judiciary.
The “Property Rights” Alternative
As might have been expected, Manne’s radical views made little progress in changing actual policy.7 The idea of legalizing insider trading was truly anathema then and has remained so to this day. The impetus to regulate the behavior of insiders was a deeply ingrained legacy of the “New Deal” era in both policy and academic circles. This was an understandable response to the virtual collapse of capitalism that began with the Crash of 1929 (see article “The Great Depression”). The 1934 report to the U.S. Senate from its Committee on Banking and Currency has already been quoted: “vicious practices . . . flagrant betrayal . . . unscrupulous employment of inside information” ( U.S. Senate, 1934, p. 55)
The SEC (2007) noted in a brief citing this report that “[t]his Senate Report is replete with examples of corporate insiders who, armed with inside information, engaged in unfair trading with market participants.” It is highly unlikely that in the first decades of the 21st century this deeply held norm is going to shift, particularly in the wake of the corporate and financial scandals that swept across the markets beginning with the collapse of the dot com stocks, followed by Enron, Worldcom and Global Crossing and then, finally, the real estate, credit market, and banking debacle of 2008–2009.
Despite their policy failure, however, law and economics scholars have been able to generate a deeper, and perhaps more interesting, argument about insider trading rooted in their insight that what is at stake is a market for “information,” more generally conceived. Macey (2009), for example, credits Manne for being “among the first to recognize that the right to trade on material, nonpublic information about a corporation was a property right that a firm should be able to allocate in order to maximize the overall value of the enterprise. He predicted that, if legalized, insider trading would evolve into an important element in a fully incentive-compatible compensation contract for managers.”8 Arguably, Manne’s original work did lay the groundwork for the growing use of stock options as a component of compensation for executives and even, particularly in the high technology sector, rank and file employees. This viewpoint was coincident with the emergence of the concept of “intellectual property” and, in light of the importance of intangible assets in today’s economy, deserves closer examination.
Following in the tradition of Manne, Easterbrook (1981) noted there is a “tension between the optimal use and optimal production of knowledge.” He viewed the regulation of insider trading in that context and suggested that such knowledge be subject to a property rights regime, a view that the world of “intellectual property” now takes for granted. Striking the right balance, however, between creation and use was far more difficult. And he waffled, in the end, concluding that “allocating opportunities” to trade to insiders “may call for difficult decisions.”
In a similar vein, more recently Bainbridge (2001, 2013a) has attempted to deal with the criticisms of Manne’s radicalism as well as what he views as the “odd sort of halfway house” (2013a, p. 90) that he believes insider trading jurisprudence is “stuck in” by advocating his view of the “property rights” analysis of insider trading. He argues that if one “steps back” to assess the issue “from first principles” then “what immediately jumps out at one is that we are really dealing with property rights in information” (p. 91). In making this move, Bainbridge is demonstrating a general concurrence with the original insight of Manne (1966, p. 59) that “in many respects the entire stock market is a complex arrangement for the marketing of information.” This allows Bainbridge to pose the question as one of allocation of a “property interest”: either to the insider or to the insider’s corporation (taking, as an example, the “classical” form of insider trading.) Generally, he concludes “the argument for assigning the property right to the insider is considerably weaker than the argument for assigning it to the corporation” (2013a, p. 95).
For Bainbridge the value of applying a property rights metaphor to trading is not that it necessarily leads back to joining Manne in a call for deregulation but rather that it provides a more coherent explanation for the boundaries set up by courts and regulators around insider trading. And that, in turn, allows for appropriate criticism of “departures from that norm” (p. 96). Thus, as an example, in one widely debated insider trading case, a newspaper reporter, Winans, was held liable for illegally trading on information in possession of his employer, but his employer, The Wall Street Journal, was not (U.S. v. Carpenter, 1986). “Because the information belonged to the [Wall Street] Journal,” Bainbridge writes, “it should have been free to use the information as it saw fit, while Winans’ use of the same information amounted to a theft of property owned by the Journal.” (p. 96)
In a second leading case, a financial analyst who enabled his clients to trade on inside information about a troubled company provided to him by a former employee of the company, was held not to be engaged in illegal trading. (Dirks v. SEC, 1983). In its opinion (again, by the conservative Justice Powell) the U.S. Supreme Court noted the important role that analysts play in facilitating market efficiency by “ferreting out” information about firms and ensuring that that information reaches the market. Bainbridge argues that this decision was, in effect, an assignment of a property right in the information about that firm “to the market analyst rather than to the affected corporation. . . the rule is justifiable [from a Bainbridgean property rights perspective] because it encourages market analysts to expend resources to develop socially valuable information about firms and thereby promote market efficiency” (p. 97). In sum, for Bainbridge, as for Manne and others writing broadly in the Hayekian tradition, insider trading should be viewed through the lens of property rights properly assigned and then monitored by the SEC, rather than as an offshoot of securities fraud, a concept they view as a vague and “inapt” (p. 98).
The Limits of the Property Rights Approach
The property rights metaphor marks a useful heuristic contribution to the insider trading debate. But its usefulness in clearing away the uncertainties that the securities fraud approach seemed to have generated is less certain. Arguably, despite Bainbridge’s assertion, it is not clear that he is really starting from genuine “first principles” when articulating an argument about a “property right in information.” More fundamentally, the starting point ought to be the recognition that the regulatory framework at issue should assist with the successful management of the capitalist system as a whole. Modern capitalism is built on a fundamental separation of ownership and control, recognized as long ago as the work of Smith, Marx and Veblen and, of course, solidified in law and economics by the fundamental, if flawed (Diamond 2019; Holderness, 2009), study of Berle and Means (1991). This separation risks evolving into a dysfunctional antinomy if not properly regulated. Regulation can emerge as the result of private ordering but, as even Bainbridge concedes, “the SEC has a comparative advantage vis-à-vis private actors in enforcing insider trading restrictions” (p. 97). In the face of this core problem, what should frame the approach to regulation? Is the definition of even a metaphorical “property right”—belonging to either the corporation or the insider or some subset of outsiders—the appropriate issue to resolve? These are important questions that should inform future research.
But it will be important to keep in mind the precise goals of the two major institutional actors in the capitalist system, the functioning or actual capitalist, on the one hand, and the money or financial capitalist, on the other, when exploring these questions. Marx (1991) made a useful distinction between these two actors but had only just began to develop this framework when he finished his major work in the area, Capital. The modern public corporation was only just emerging as an important institution in the late 19th century when Marx died. Very little work since then has built on this original and important distinction. There is, of course, a long history of what might be called “populist” analysis of tensions between financial and industrial capital, but these fail to grasp the essentially shared capitalist origins of the two actors. Much of this kind of work tends to view financial capitalists as playing a passive rentier role, with some viewing finance more harshly as parasitical (Diamond, 2008; Krier, 2005). Typically, those who advocate deregulation of insider trading such as Boudreaux (2009) favor granting a firm’s managers the right to decide what information should and should not be protected from insider trading. They assume that financial actors can passively rely on the consequential impact on stock prices to decide whether the managers made the right allocation.
Active, or functioning, capitalists are those individuals responsible for the management of the work process whereby value is created and appropriated by the firm. Generally speaking, these kinds of capitalists will have most of their human capital invested in that single firm. They will, assuming they are self-interested, want to maximize the returns they can generate from their own activities inside a firm. Financial capitalists, on the other hand, are typically diversified across an array of assets. This tendency towards diversification has grown dramatically in the last few decades with the rise of institutional investors. Financial capitalists are arguably, as a class, the most general representative of the capitalist economy as a whole. They have an interest in learning as much as possible about each of their investments, or, what amounts to the same thing, in ensuring that the financial markets have as much accurate information as possible so that they can generate accurate and timely estimates of future value. This will enable financial capitalists to allocate capital more accurately between firms and sectors. It will also lower their costs of trading financial assets as bid–ask spreads charged by market makers narrow, as explained above in the “Introduction.”
Both these important institutional actors thus play very different and important roles in capitalism. This differentiation can lead to varying approaches to information and, potentially, to conflict over the rights to information. More attention by researchers to this institutional structure could bring greater clarity and understanding of these differences, lead to awareness of the different motives or incentives driving each set of actors, and result in less costly and uncertain negotiations over the allocation of the rights to proprietary information.
While property rights advocates might suggest that their framework is sufficient to provide the principles needed to resolve this conflict, in fact, as Bainbridge concedes, the government has an important role to play in regulating the allocation of rights to information. That raises the question of what principles should shape government decision-making. Here, the Hayekian view proves largely worthless. Manne, Bainbridge and others in the deregulatory school reject claims that fairness should or, in fact, does drive regulation. Bainbridge (2001) dismisses the concept as “high sounding but essentially content-less” (p. 62). Levmore dismisses the fairness alternative to what he views as the “free-market approach” as “a standard that has been supported more by dramatic pronouncements than by rigorous analysis” (p. 119). Epstein (2016) calls the SEC’s fairness approach “ad hoc.”
Instead, law and economics scholars rely on the lessons of the public choice school to claim that the SEC has an unwavering interest in expanding its regulatory turf and thus will leave no stone unturned to impose an aggressive approach to insider trading (Niskanen, 1971; Dooley, 1995; Haddock & Macey, 1987; Macey, 1991; Epstein, 2016). They prefer, then, to view the decision about allocating rights to information as merely an aspect of the “law of contracts” between private actors, presumably with, at best, a light touch by the courts, and an even more distant role for the SEC (Levmore, 1982, p. 159; see also Epstein, 2016).
This approach, however, likely underestimates or, perhaps, misunderstands the purpose of invoking the fairness concern at the heart of the “disclose or abstain” approach of the SEC and the pre- and post-Powell Supreme Court. First, fairness is not the sole motivating value. It is generally linked by regulators to a second, closely intertwined concern with “integrity.” The SEC has made this clear frequently. As it stated (2018) on its website, “Because insider trading undermines investor confidence in the fairness and integrity of the securities markets, the SEC has treated the detection and prosecution of insider trading violations as one of its enforcement priorities.”
This concern with integrity has been reinforced by Supreme Court interpretations of the law which the SEC administers. According to the O’Hagan Court (1997) the misappropriation theory it adopted in order to expand liability for insider trading to outsiders who trade using material information taken in breach of a fiduciary duty is important because “investors likely would hesitate to venture their capital in a market where trading based on misappropriated nonpublic information is unchecked by law” (p. 658). The Court cited the work of Brudney (1979) which encapsulated the “lemons” concern even if not expressly tying it to the fundamental economic analysis: “If the market is thought to be systematically populated with . . . transactors [trading on the basis of misappropriated information] some investors will refrain from dealing altogether, and others will incur costs to avoid dealing with such transactors or corruptly to overcome their unerodable informational advantages.” Brudney agrees that whatever one makes of the “fairness” idea, “there is a sound functional basis for the rule.” (Brudney, 1979, p. 355).
Of course, as suggested in the Introduction above, there is a powerful economic insight underlying this concern shaped by Akerlof’s work on the famous “lemons problem.” If buyers cannot easily discern the difference between good-quality and poor-quality products in a market, they will likely offer discounted prices for both. Sellers of good-quality products may then decide to exit the market because they will not be able to get what they perceive is the right price for their goods. In extremis that could lead to market collapse as buyers, in turn, exit because they realize there is less and less of a chance of getting a good-quality product. Lemons theory has been applied to the financial markets (Diamond and Kuan, 2018; Kurlat, 2013). The question arises, then: who is fundamentally responsible for solving this problem? Within the framework of capitalism that responsibility naturally falls to the state. This is what has explained the bursts of government intervention in the wake of financial crises for some decades—the original federal securities laws in the 1930s after the Crash and ensuing Depression; and, more recently, the Sarbanes–Oxley Act of 2002 in the wake of corporate malfeasance in the collapsed telecom sector and the Dodd–Frank Act of 2010 in the wake of the credit crisis and mortgage bubble collapse.
Inevitably, the Hayekians reject these interventions as government over-reach. But no credible substitute is articulated by this school other than a resort once again to the invisible hand of the competitive market. In the eyes of Richard Epstein, for example, the current insider trading regime “reaches too far” in some cases and “not . . . far enough” in others. He casts the “personal benefit” test applied to tippees as a needless distraction that places too much of a burden on the government. On the other hand, he concurs with other critics in their attack on the SEC’s “level playing field” approach. Predictably, he claims that private ordering can resolve many of these problems.
With respect to the former, he advocates borrowing from common law the idea of placing a “constructive trust” on inside information to mitigate any “unjust enrichment” in cases where they are currently forced to apply the muddled “personal benefit” test. Thus, in cases such as Dirks, unlike his fellow law and economics colleague Bainbridge, Epstein would have found the financial analyst Dirks liable because while performing a social good in ferreting out information about the corrupt company he was researching, he nonetheless helped his clients avoid losses by using information that did not belong to them. And in cases involving misappropriation, Epstein would replace the application of federal securities laws with “private sanctions that regulate the uneven flow of information.”
Of course, after decades of volatility veering into outright crisis and even collapse of financial markets, it might be more prudent to conclude that the invisible hand is invisible because it is illusory. Indeed, there is a fundamental problem that makes this free market obsession inherently unworkable: it largely ignores the anarchic nature of capitalism. By definition, even in oligarchic sectors, capitalist firms are badly divided, and investors are widely dispersed. Neither active nor financial capitalists, therefore, can easily coalesce to develop private ordering-based solutions to the integrity problem. It would be inordinately time-consuming, expensive and complex to knit together a rule structure that determined who can trade, and when, on inside information firm by firm, much less in a manner that is easily digestible so that market makers can engage in appropriate discounting. Where would investors prefer to swim—in a body of water where sharks are free to roam without monitoring, or in a setting where there is some kind of regulatory body responsible for public safety? Together with fairness, a concern for integrity points to the need for an overarching supervisory framework for the financial markets lest a second 1929 occur.
Fairness, however much dismissed as merely a moral stance, articulates a closely related value that deserves more attention. The significance of this value should motivate other disciplines, outside of law and economics, to pay closer attention to what happens in the financial markets. To date, sociology, anthropology, political science, history, and philosophy, have largely left this field to a very ideologically constrained group of scholars. Illustrative exceptions include Riles (2011; 2013), Davis (2009), Krier (2005) and Lazar (1990). But in those other fields there is a rich literature and deep concern for the importance of fairness. For example, in the older, now somewhat passé, field of industrial relations—arguably centered in history, political science and sociology, but also with an important presence in a pre-neoliberal era of law and economics—it was understood that fairness was a critical factor. A sense of fairness in the outcomes of institutions like collective bargaining was considered vital to the post-World War II success of capitalism. With the decline of unionization over the past three decades and the consequent rise in inequality (Card, 1998; Piketty, 2013) that sense of fairness has been undermined (Diamond, 2003; Stone, 1981). Zingales (2017) notes “that the interaction of concentrated corporate power and politics is a threat to the functioning of the free market economy and to the economic prosperity it can generate, and a threat to democracy as well” (p. 114).
While there are serious limitations, then, to the property rights/ public choice approach, the concerns raised by critics of the regulation of insider trading should be taken seriously. In doing so, we help highlight areas where theory is under-developed and empirical research is needed to grasp the significance of a fairness/ integrity-based alternative argument for regulatory intervention. Future multidisciplinary work, therefore, could focus on deepening our understanding of the rational basis for regulatory intervention in light of its role in stabilizing an unpredictable and anarchic system heavily biased towards under-regulation. It would be interesting, for example, to examine the relationship between what some empirical research suggests is a recent increase in SEC enforcement of insider trading with the decline in institutions such as unionization and collective bargaining that were thought to contribute to that sense of fairness.
The “law and economics” attack on insider trading regulation, whether the legalization approach Manne introduced, or the contractarian solution advocated by Epstein or the more nuanced design favored by Bainbridge, have set the terms of much of the academic debate over the last several decades. But in the meantime, the potential problems associated with insider trading have been subject to research from more traditional approaches. A review of three of the major areas of interest remind us that there is useful work to be done on the problem outside of this ideological conflict. These “open questions” include attempting to quantify the size of the problem, examining the impact of recent changes in the structure of the capital markets and, finally, assessing the risks of so-called “political” insider trading. These questions remind us that insider trading cannot be so easily dismissed as the law and economics adherents seem to suggest.
How Big Is the Problem?
The ink spilled debating insider trading is massive. The tabloid-friendly arrests of corporate insiders and hedge fund managers—so-called “perp” walks where indicted traders are walked into courthouses by agents of the Federal Bureau of Investigation in full view of the media—only heighten the sense that improper trading by “insiders” is a very significant problem in the financial markets. However, as Tamersoy et al. (2014) note, “detecting illegal trades in the large pool of reported trades is challenging” (p. 2). Kurlat (2013) suggests, in fact, that asymmetric information—of which insider trading is one version—may contribute to “large fluctuations” in the economy in the absence of readily apparent exogenous shocks. But it remains the case that we do not have definitive data on the precise scale of the kind of insider trading discussed here. Manne (2005) took advantage of the paucity of data to suggest that insider trading was like, borrowing from the Arthur Conan Doyle Sherlock Holmes short story, the “dog that did not bark”—in other words, fears of massive insider trading were overblown. Naturally, this bolstered his original deregulation argument made four decades earlier.
Nonetheless, valid attempts to quantify the problem have been made. Beny and Seyhun (2013) document an increased level of enforcement coincident with some market indicators of increased insider trading but they note that their results explain increased profitability of insider trading, which may not be the same thing as an increased volume of such trading. Their results are based on price changes of securities in advance of the announcement of takeover bids, certainly an important object for insider trading schemes but not the only one. Seyhun and Bradley (1997) “find that corporate insiders engage in significant sales prior to filing a bankruptcy petition and, as a result, avoid significant capital losses” (p. 191), arguably coloring in another element of the picture. More recently, Tamersoy et al. (2014) “present the first effort to systematically analyze insider trades in a large-scale setting.” The results are troubling: “We determine that a significant portion of the insiders makes short-swing profits despite the existence of a rule designed to prevent short-swing trading; We discover a set of insiders who time their trades well: They buy when the price is low or sell when the price is high in comparison with the market closing price” (p. 2).
What Is the Impact of Changing Market Structure?
With the implementation of Regulation NMS (which is an acronym for “national market system”) in 2007, the U.S. stock markets underwent a dramatic restructuring. (Diamond & Kuan, 2007, 2018). The new rule set dismantled the protective barrier around the trading floor of the New York Stock Exchange. As a result, competing trading venues including the Nasdaq and new electronic communications networks that had begun to spring up, were able to execute trades in NYSE-listed securities at prices that were no longer bound by the prices set by specialists on the NYSE trading floor. The result was a complex pricing structure that has apparently enabled certain trading firms engaged in high-speed algorithm-based trading to outsmart other investors (HFTs—“high frequency traders”). So-called “predatory” high-frequency trading has been likened to illegal forms of insider trading because the HFTs are taking advantage of information about trades that other investors are making in advance of the final execution of those trades. There are allegations, as well, that the trading venues are facilitating this form of informed trading by making incentive payments to brokerages to route substantial trading volume to their venues where those trades are, in essence, “picked off” by predatory HFTs.
Yadav (2016) calls these HFTs “algorithmic ‘structural insiders’” who “by virtue of speed and physical proximity to exchanges—systematically gain first access to information and play an outsize role in price formation.” Diamond and Kuan (2018) report that bid–ask spreads in NYSE-listed stocks widened when trading in those stocks moved to the Nasdaq after the implementation of Reg. NMS. Spreads generally widen in the face of adverse selection risk which may rise when “structural insiders” are exploiting an information advantage. The post-Reg. NMS fragmentation of market structure—where dozens of venues might offer to execute a trade in a particular stock—was intended by the SEC to improve price efficiency and lower investor cost with competition. But, in fact, it may be giving rise to new advantages to those with better information about trading patterns. Barbon, Di Maggio, Franzoni and Landier (2017) flag concerns about information leakage by brokers to favored clients when executing large trades broken up over several trading days. Di Maggio, Franzoni, Kermani and Sommavilla (2017) highlight a similar concern with a focus on broker networks.
Politically Informed Trading
Given the tremendous importance of government policy and regulation for the functioning of business it is not a surprise to learn that access to nonpublic information about those policies and regulations could enable a trader to gain at the expense of other traders. Leaving aside actual stealing of such information, certain individuals are likely to have access to such information via legitimate means. There are, of course, the regulators and politicians themselves along with their staff members. In addition, private sector figures participate in a wide range of government commissions, task forces, and committee hearings where they may glean information that gives them a trading advantage. (Jagolinzer, Larcker, Ormazabal & Taylor, 2018). Trading by U.S. Congresspersons and their staffs was only outlawed in 2012 after several years of public reporting of politicians trading in the stocks over which they had regulatory oversight authority. But controversy persists. Part of the 2012 law was repealed a year later, quietly undoing a key recordkeeping requirement of the original law. One study by a watchdog group (Holman, 2017) found “that the law appears to have had a dramatic impact on stock trading activity. Both the transaction values of stock trades, and the number of stock transactions, have significantly declined since passage of the STOCK Act” (p. 3).
Surprisingly, SEC employees are allowed to trade in stocks and, one study found, they earn “abnormal risk-adjusted profits” on some of those trades (Rajgopal & White, 2017, p. 442). A preliminary version of this study, however, was sharply criticized by Solomon (2014) and Romanek (2014). One explanation for the SEC staff’s trading profits, which occurred on sales more than on purchases, is that they are mandated to sell in advance of an investigation of a stock by the Commission. Naturally, those stocks are subject to a potential decline once an investigation is announced. While this was explained away as innocent, it does highlight that, like firms, the SEC possesses material nonpublic information and if it allows staff to buy and then sell it is, in a sense, awarding the rights to that information to its staff. Rajgopal and White conclude that the problem “would be solved by a simple, bright-line rule prohibiting SEC employees from trading in individual stocks” (p. 443).
Markets that deal with intangible goods are inherently fragile. The stock market deals in perhaps the most intangible asset of all, information. While that market functions better with more information it also needs to have a mechanism in place to distribute that information in a manner that is socially optimal. The participants in a stock market will never have complete information. An economy based on competition between private owners of firms means that some information will always remain off the market. In the face of that “incomplete information” problem it should be accepted that stock markets depend on buyers and sellers feeling confident that the price they strike for shares in a transaction is close to the right price. The parties to these trades must, therefore, believe—even in the face of incomplete information—that they are dealing with an asset they both understand and can assess within a balanced range of equality. That increases the chances that they will, in fact, trade, as opposed to leaving the market altogether fearing that they are being taken advantage of by so-called “informed traders,” and that their final agreed price is as close to the actual value of the firm as can be reasonably expected.
The concern that buyers and sellers may abandon a market when their confidence in these expectations decreases is likely underestimated. Even in the wake of the series of corporate and financial scandals of the early 21st century the U.S. stock markets remain robust centers of trading and a model for global capital markets. But that should not lull anyone into a false sense of confidence. Markets can and do fail, and they likely suffer from partial failures more often than we recognize.
On May 6, 2010, for example, a dramatic price drop, now known widely as the “Flash Crash,” shocked major stock indices in the United States. Within five minutes nearly 1000 points had been wiped off the Dow Jones Index—approximately $1 trillion or 9 % of its value. While the market recovered quickly, it was clear when the dust had settled that for a brief period of time buyers of stocks had all but disappeared. In their detailed description of the “liquidity crisis” the stock market faced that day, the SEC and CFTC noted that “some market makers and other liquidity providers widened their quote spreads, others reduced offered liquidity, and a significant number withdrew completely from the markets” (SEC-CFTC, 2010, p. 5 (emphasis added)). Such an extreme volatility event should be exceptionally rare, if not impossible, and yet it happened. Smaller versions of the Flash Crash now occur on a regular basis in the capital markets typically hitting individual stocks. One study discovered more than 5,000 such “mini-crashes” during a four-month period (Golub, Keane, & Poon, 2012).
It is time, therefore, to close the debate about the legality of insider trading. The law and economics school has had more than five decades to establish its case for wider legalization of such trading. Instead of continuing to put the Manne proposal at the heart of the discussion, as many still do, it is time to focus, as the SEC and the federal judiciary has done, on the right standards and rules needed to strike, as a central law and economics scholar, Judge Frank Easterbrook has put it, the right balance between production and use of knowledge.
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1. It is useful to limit this statement by suggesting it is “arguably” true because it depends on a model of price impact that requires faith in the efficient market hypothesis (“EMH”). Of course, several schools of thought—behavioralism, chaos theory—have called this widely accepted hypothesis into question, particularly since the unexplained volatility of the financial markets during events like 1987’s “Black Monday” or the dotcom bubble and subsequent crash. On the EMH see Fama (1965, 1970), on behavioral explanations for market bubbles see Shiller (2003) and Shleifer (2000), on chaos theory see Peters (1994) and for a more recent defense of the EMH in the face of widespread criticism see Malkiel (2003).
2. In 2019, a bill was passed by the U.S. House of Representatives’ Committee on Financial Services which would amend the Exchange Act to include a new Section 16A entitled the “Insider Trading Prohibition Act.” If made into law, which is far from certain, this new section would expressly prohibit trading on material nonpublic information. The triggers for illegal trading would be broader in reach than the current common law standard. (Henning, 2019). There is also one partial exception to the statement that the current law does not expressly outlaw insider trades. Section 16 of the Securities Exchange Act of 1934, as amended (“Exchange Act”) does prohibit so-called “short swing profits” earned by certain insiders when they buy (sell) a firm’s securities and then sell (purchase) them within a six-month time frame. The broadly worded prohibition forces many trades to unwind that are not affected by inside information and can miss many that are so affected. Thus, this kind of trade is outside the scope of this article. This is not an endorsement of the view of the “law and economics” school that the legislative history underlying Section 16 is not relevant to the broader discussion of the rationale for insider trading. It is not correct to credit, negatively, as these critics often do, the SEC with reading into the federal statutes a prohibition on insider trading. As the SEC (2007) has explained about Section 16, “The Supreme Court has repeatedly recognized that ‘the only method Congress deemed effective to curb the evils of insider trading was a flat rule [i.e., Section 16] taking the profits out of a class of transactions in which the possibility of abuse was believed to be intolerably great.’[Citations omitted.] ‘. . . This approach maximized the ability of the rule to eradicate speculative abuses by reducing difficulties in proof.’ [Citations omitted.]” For a scholarly view that Section 16 is intended as a robust barrier to inappropriate insider trading, see Thel (1991). Also outside the scope of this article is Regulation FD, which mandates that publicly traded firms, when they do announce new information about their companies to the markets, do so to all investors at the same time.
3. U.S. v. O’Hagan, 521 U.S. 642, 661 (1997).
4. SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 848 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969). If problematic to law and economics scholars, “[t]his rationale . . . at least was linked to a core problem of securities regulation; namely, controlling flows of information to the capital markets” (Bainbridge, 2013a at 80). As explained below, this aggressive approach is now limited by the requirement that the insider be in breach of a fiduciary obligation when they trade or provide the relevant information to others who trade.
5. See, e.g., Dirks v. SEC, 463 U.S. 646 (1983).
6. See Dirks v. SEC, 463 U.S. 646, 662 (1983); SEC v. Yun, 327 F.3d 1263, 1269 (11th Cir. 2003).
7. Even Manne’s acolytes admit that his proposals “stunned the corporate law academy” world; thus it is not a stretch to consider them “radical” (Bainbridge, 2009, p. vii). Consequently, it is not a surprise that a search of the Lexis federal courts database reveals only a single citation of Manne’s work (Freeman v. Decio, 584 F.2d 186, 190 (CA7, 1986)), albeit an accurate restatement of the “efficiency” prong of Manne’s analysis.
8. Despite the disquiet among law and economics scholars like Manne, Macey, and Bainbridge about the straitjacket placed on insiders, securities granted to insiders have remained subject to the broad insider trading prohibition (Diamond, 2013).