Archives For insider trading

On June 23 the Supreme Court regrettably declined the chance to stem the abuses of private fraud-based class action securities litigation.  In Halliburton v. EPJ Fund (June 23, 2014), a six-Justice Supreme Court majority (Chief Justice Roberts writing for the Court, joined by Kennedy, Ginsburg, Breyer, Sotomayor, and Kagan) reversed the Fifth Circuit and held that a class action certification in a securities fraud case should be denied if the defendants produce evidence rebutting the presumption that defendants’ misrepresentations had a price impact. EPJ Fund filed a class action against Halliburton and one of its executives, alleging that they made misrepresentations designed to inflate Halliburton’s stock price, in violation of Section 10(b)(5) of the Securities Exchange Act of 1934 and Securities and Exchange Commission Rule 10b-5. In Basic v. Levinson (1988), the Supreme Court held that: (1) investors could satisfy the requirement that plaintiffs relied on defendants’ misrepresentations in buying stock by invoking a presumption that the price of stock traded reflects all public, material information, including material misrepresentations; but that (2) defendants could rebut this presumption by showing that the misrepresentations had no price impact.  Halliburton argued that class certification was inappropriate because the evidence it introduced to disprove loss causation also showed that its alleged misrepresentations had not affected its stock price, thereby rebutting the presumption. The district court rejected Halliburton’s argument and certified the class, and the Fifth Circuit affirmed, concluding that Halliburton could use its evidence only at trial. Although the Court rejected Halliburton’s arguments for overturning Basic, it agreed with Halliburton that defendants must be afforded an opportunity to rebut the presumption of reliance before class certification, because the fact that a misrepresentation has a price impact is “Basic’s fundamental premise.”

Justice Thomas, joined by Scalia and Alito, concurred in the judgment, but argued that the “fraud on the market” (FOTM) theory embodied in Basic should be overruled, based on logic, economic realities (“market efficiency has . . . lost its luster”), and subsequent jurisprudence clarifying class certification requirements.  Significantly, the Thomas dissent points to a variety of well-recognized motives for the purchase of securities that have nothing to do with a presumption (key to the FOTM theory) that the market accurately reflects the value of a stock in light of all public information:  “Many investors in fact trade for the opposite reason—that is, because they think the market has under- or overvalued the stock, and they believe they can profit from that mispricing. . . .  Other investors trade for reasons entirely unrelated to price—for instance, to address changing liquidity needs, tax concerns, or portfolio balancing requirements. . . .  In short, Basic’s assumption that all investors rely in common on price integrity is simply wrong.”  [citation omitted]

Thomas, Scalia, and Alito are right – the Court’s majority missed a major opportunity to rein in class action opportunism by failing to consign Basic to the graveyard of economically flawed Supreme Court precedents, where it belongs.  Given the costs and difficulties inherent in rebutting the presumption of reliance at the class action stage, Halliburton at best appears likely to impose only a minor constraint on securities fraud class actions.

The FOTM presumption that has enabled a substantial rise in securities class action litigation over the last quarter century makes no economic sense, according to the scholarly consensus.  What’s more, it imposes a variety of social harms on the very groups that were supposed to benefit from this doctrine, as described in a recent study of the political economy of FOTM.  Specifically, longer-term shareholders end up bearing the cost of class action settlements that benefit plaintiffs’ trial lawyers, and to the extent paying and receiving shareholders are fully diversified, FOTM is a wash in terms of compensation that turns into a net loss when costs including attorneys’ fees are included.  Moreover, FOTM’s utility as a fraud deterrent is “much muted” because payments are made by the corporation and its insurer, not the individual culpable agents.  In short, “[w]hen the dust settles, FOTM not only fails to meet its stated goals, it does not even try.”

Not included in this litany of FOTM’s shortcomings is the serious issue of error costs, and in particular the harmful avoidance of novel but efficient behavior by corporate officials that fear it will incorrectly be deemed “fraudulent.”  This largely stems from the fact that “fraud” is not precisely defined in the securities law context, which has led to “at least three costs: public and private actions are not brought on behalf of clearly specified regulatory objectives; the line between civil and criminal liability has become unacceptably blurred; and the law has come to provide at best a weak means of resolving vital public questions about wrongdoing in financial markets.

In light of these problems, Congress should eliminate the eligibility of private securities fraud suits for class action certification.  Moreover, Congress should require a showing of specific reliance on fraudulent information as a prerequisite to any finding of liability in a private individual action.  What’s more, Congress ideally should require that the SEC define with greater specificity what categories of conduct it will deem actionable fraud, based on economic analysis, as a prerequisite for bringing enforcement actions in this area.

Public choice insights suggest this wish list will be difficult to obtain, of course (but not impossible, as passage of the Class Action Fairness Act of 2005 demonstrates).  Public support for reform might be sparked by drawing greater attention to the fact that class action securities litigation has actually tended to harm, rather than help, small investors.

What about even more far-reaching securities law reforms?  Asking Congress to consider decriminalizing insider trading undoubtedly is unrealistic at this juncture, but it is interesting to note that even mainstream journalists are starting to question the social utility of the SEC’s current crackdown on insider trading.  This focus may lead to a serious case of misplaced priorities.  Notably, as leading Federal District Court Judge (SDNY) and former Assistant U.S. Attorney (AUSA) Jed Rakoff has stressed, AUSAs avoid pursuing far more serious frauds arising out of the 2008 Financial Crisis in favor of bringing insider trading cases because the latter are easier to investigate and prosecute in a few years’ time, and, thus, best enhance the AUSAs’ marketability to law firms.  (Hat tip to my Heritage colleague Paul Larkin for the Rakoff reference.)

TOTM friend Stephen Bainbridge is editing a new book on insider trading.  He kindly invited me to contribute a chapter, which I’ve now posted to SSRN (download here).  In the chapter, I consider whether a disclosure-based approach might be the best way to regulate insider trading.

As law and economics scholars have long recognized, informed stock trading may create both harms and benefits to society With respect to harms, defenders of insider trading restrictions have maintained that informed stock trading is “unfair” to uninformed traders and causes social welfare losses by (1) encouraging deliberate mismanagement or disclosure delays aimed at generating trading profits; (2) infringing corporations’ informational property rights, thereby discouraging the production of valuable information; and (3) reducing trading efficiency by increasing the “bid-ask” spread demanded by stock specialists, who systematically lose on trades with insiders.

Proponents of insider trading liberalization have downplayed these harms.  With respect to the fairness argument, they contend that insider trading cannot be “unfair” to investors who know in advance that it might occur and nonetheless choose to trade.  And the purported efficiency losses occasioned by insider trading, liberalization proponents say, are overblown.  There is little actual evidence that insider trading reduces liquidity by discouraging individuals from investing in the stock market, and it might actually increase such liquidity by providing benefits to investors in equities.  With respect to the claim that insider trading creates incentives for delayed disclosures and value-reducing management decisions, advocates of deregulation claim that such mismanagement is unlikely for several reasons.  First, managers face reputational constraints that will discourage such misbehavior.  In addition, managers, who generally work in teams, cannot engage in value-destroying mismanagement without persuading their colleagues to go along with the strategy, which implies that any particular employee’s ability to engage in mismanagement will be constrained by her colleagues’ attempts to maximize firm value or to gain personally by exposing proposed mismanagement.  With respect to the property rights concern, deregulation proponents contend that, even if material nonpublic information is worthy of property protection, the property right need not be a non-transferable interest granted to the corporation; efficiency considerations may call for the right to be transferable and/or initially allocated to a different party (e.g., to insiders).  Finally, legalization proponents observe that there is little empirical evidence to support the concern that insider trading increases bid-ask spreads.

Turning to their affirmative case, proponents of insider trading legalization (beginning with Geoff’s dad, Henry Manne) have primarily emphasized two potential benefits of the practice.  First, they observe that insider trading increases stock market efficiency (i.e., the degree to which stock prices reflect true value), which in turn facilitates efficient resource allocation among capital providers and enhances managerial decision-making by reducing agency costs resulting from overvalued equity.  In addition, the right to engage in insider trading may constitute an efficient form of managerial compensation.

Not surprisingly, proponents of insider trading restrictions have taken issue with both of these purported benefits. With respect to the argument that insider trading leads to more efficient securities prices, ban proponents retort that trading by insiders conveys information only to the extent it is revealed, and even then the message it conveys is “noisy” or ambiguous, given that insiders may trade for a variety of reasons, many of which are unrelated to their possession of inside information.  Defenders of restrictions further maintain that insider trading is an inefficient, clumsy, and possibly perverse compensation mechanism.

The one thing that is clear in all this is that insider trading is a “mixed bag”  Sometimes such trading threatens to harm social welfare, as in SEC v. Texas Gulf Sulphur, where informed trading threatened to prevent a corporation from usurping a valuable opportunity.  But sometimes such trading creates net social benefits, as in Dirks v. SEC, where the trading revealed massive corporate fraud.

As regular TOTM readers will know, optimal regulation of “mixed bag” business practices (which are all over the place in the antitrust world) requires consideration of the costs of underdeterring “bad” conduct and of overdeterring “good” conduct.  Collectively, these constitute a rule’s “error costs.”  Policy makers should also consider the cost of administering the rule at issue; as they increase the complexity of the rule to reduce error costs, they may unwittingly drive up “decision costs” for adjudicators and business planners.  The goal of the policy maker addressing a mixed bag practice, then, should be to craft a rule that minimizes the sum of error and decision costs.

Adjudged under that criterion, the currently prevailing “fraud-based” rules on insider trading fail.  They are difficult to administer, and they occasion significant error cost by deterring many instances of socially desirable insider trading.  The more restrictive “equality of information-based” approach apparently favored by regulators fares even worse.  A contractarian, laissez-faire approach favored by many law and economics scholars would represent an improvement over the status quo, but that approach, too, may be suboptimal, for it does nothing to bolster the benefits or reduce the harms associated with insider trading.

My new book chapter proposes a disclosure-based approach that would help reduce the sum of error and decision costs resulting from insider trading and its regulation.  Under the proposed approach, authorized informed trading would be permitted as long as the trader first disclosed to a centralized, searchable database her insider status, the fact that she was trading on the basis of material, nonpublic in­formation, and the nature of her trade.  Such an approach would (1) enhance the market efficiency benefits of insider trading by facilitating “trade decod­ing,” while (2) reducing potential costs stemming from deliberate misman­agement, disclosure delays, and infringement of informational property rights.  By “accentuating the positive” and “eliminating the negative” conse­quences of informed trading, the proposed approach would perform better than the legal status quo and the leading proposed regulatory alternatives at minimizing the sum of error and decision costs resulting from insider trading restrictions.

Please download the paper and send me any thoughts.

Regular readers will know that several of us TOTM bloggers are fans of the “decision-theoretic” approach to antitrust law.  Such an approach, which Josh and Geoff often call an “error cost” approach, recognizes that antitrust liability rules may misfire in two directions:  they may wrongly acquit harmful practices, and they may wrongly convict beneficial (or benign) behavior.  Accordingly, liability rules should be structured to minimize total error costs (welfare losses from condemning good stuff and acquitting bad stuff), while keeping in check the costs of administering the rules (e.g., the costs courts and business planners incur in applying the rules).  The goal, in other words, should be to minimize the sum of decision and error costs.  As I have elsewhere demonstrated, the Roberts Court’s antitrust jurisprudence seems to embrace this sort of approach.

One of my long-term projects (once I jettison some administrative responsibilities, like co-chairing my school’s dean search committee!) will be to apply the decision-theoretic approach to regulation generally.  I hope to build upon some classic regulatory scholarship, like Alfred Kahn’s Economics of Regulation (1970) and Justice Breyer’s Regulation and Its Reform (1984), to craft a systematic regulatory model that both avoids “regulatory mismatch” (applying the wrong regulatory fix to a particular type of market failure) and incorporates the decision-theoretic perspective. 

In the meantime, I’ve been thinking about insider trading regulation.  Our friend Professor Bainbridge recently invited me to contribute to a volume he’s editing on insider trading.  I’m planning to conduct a decision-theoretic analysis of actual and proposed insider trading regulation.

Such regulation is a terrific candidate for decision-theoretic analysis because stock trading on the basis of material, nonpublic information itself is a “mixed bag” practice:  Some instances of insider trading are, on net, socially beneficial; others create net welfare losses.  Contrast, for example, two famous insider trading cases:

  • In SEC v. Texas Gulf Sulphur, mining company insiders who knew of an unannounced ore discovery purchased stock in their company, knowing that the stock price would rise when the discovery was announced.  Their trading activity caused the stock price to rise over time.  Such price movement might have tipped off landowners in the vicinity of the deposit and caused them not to sell their property to the company (or to do so only at a high price), in which case the traders’ activity would have thwarted a valuable corporate opportunity.  If corporations cannot exploit their discoveries of hidden value (because of insider trading), they’ll be less likely to seek out hidden value in the first place, and social welfare will be reduced.  TGS thus represents “bad” insider trading.  
  • Dirks v. SEC, by contrast, illustrates “good” insider trading.  In that case, an insider tipped a securities analyst that a company was grossly overvalued because of rampant fraud.  The analyst recommended that his clients sell (or buy puts on) the stock of the fraud-ridden corporation.  That trading helped expose the fraud, creating social value in the form of more accurate stock prices.

These are just two examples of how insider trading may reduce or enhance social welfare.  In general, instances of insider trading may reduce social welfare by preventing firms from exploiting and thus creating valuable information (as in TGS), by creating incentives for deliberate mismanagement (because insiders can benefit from “bad news” and might therefore be encouraged to “create” it), and perhaps by limiting stock market liquidity or reducing market efficiency by increasing bid-ask spreads.  On the other hand, instances of insider trading may enhance social welfare by making stock markets more efficient (so that prices better reflect firms’ expected profitability and capital is more appropriately channeled), by reducing firms’ compensation costs (as the right to engage in insider trading replaces managers’ cash compensation—on this point, see the excellent work by our former blog colleague, Todd Henderson), and by reducing the corporate mismanagement and subsequent wealth destruction that comes from stock mispricing (mainly overvaluation of equity—see work by Michael Jensen and yours truly).

Because insider trading is sometimes good and sometimes bad, rules restricting it may err in two directions:  they may acquit/encourage bad instances, or they may condemn/prevent good instances.  In either case, social welfare suffers.  Accordingly, the optimal regulatory regime would seek to minimize the sum of losses from improper condemnations and improper acquittals (total error costs), while keeping administrative costs in check.

My contribution to Prof. Bainbridge’s insider trading book will employ decision theory to evaluate three actual or proposed approaches to regulating insider trading:  (1) the “level playing field” paradigm, apparently favored by many prosecutors and securities regulators, which would condemn any stock trading on the basis of material, nonpublic information; (2) the legal status quo, which deems “fraudulent” any insider trading where the trader owes either a fiduciary duty to his trading partner or a duty of trust or confidence to the source of his nonpublic information; and (3) a laissez-faire, “contractarian” approach, which would permit corporations and sources of nonpublic information to posit their own rules about when insiders and informed outsiders may trade on the basis of material, nonpublic information.  I’ll then propose a fourth disclosure-based alternative aimed at maximizing social welfare by enhancing the social benefits and reducing the social costs of insider trading, while keeping decision costs in check. 

Stay tuned…I’ll be trying out a few of the paper’s ideas on TOTM.  I look forward to hearing our informed readers’ thoughts.

Professor Bainbridge is urging his readers to pressure Eric Cantor into dropping his opposition to pending legislation that would ban Congressional insider trading.  But before you Twitter Cantor, please read Todd Henderson and my Politico column, in which we make the following point, among others:

A prohibition on trading would be impossible to enforce because congressmembers have so many opportunities to use information without trading on it. They could trade tips or exchange them for political favors. Given the pervasiveness of political events, the Securities and Exchange Commission would face an impossible task of identifying the trading from market movements — its usual tool for tracking insider trading.

If the SEC did try to enforce the ban, it could chill legitimate information flows on Capitol Hill and create a powerful tool for political parties to deploy against their enemies. Moreover, the SEC itself would be exposed to accusations of political favoritism — which could undermine its market-policing role. Conflict-of-interest allegations, like those during the Madoff investigation, would become routine.

The SEC is already embroiled in more politics than you want a market regulator to be.  Does it really need to start regulating Congress?  I think this Act needs more thought and less Twittering.

Let Congress trade!

Larry Ribstein —  2 December 2011

I have previously discussed here and here the policy arguments against a broad ban on Congressional insider trading (this is apart from Steve Bainbridge’s serious problems with the proposed legislation).  

Now Todd Henderson and I have weighed in on Politico with more on why we should let Congress trade (while imposing strong disclosure duties).  It’s obviously not a popular position these OWS and politician-bashing days. But we think it’s a sensible one that deserves serious consideration.

Update:  Bainbridge responds.  He focuses on the perverse incentive problem, which Todd and I acknowledge.  Unfortunately, he ignores our argument for disclosure as a way of dealing with that issue, and the serious problems of having the SEC enforce a Congressional insider trading ban.  Consideration of these issues caused me to change my views on banning Congressional insider trading.  I think it’s inconsistent to focus on enforcement problems in banning private activity (as both Bainbridge and I do) and not do so in banning public conduct, where enforcement is even trickier.

Not, as economic theory would predict, because they need the money, according to Bhattacharya and Marshall, Do They Do it for the Money?  Here’s the abstract:

Using a sample of all top management who were indicted for illegal insider trading in the United States for trades during the period 1989-2002, we explore the economic rationality of this white-collar crime. If this crime is an economically rational activity in the sense of Becker (1968), where a crime is committed if its expected benefits exceed its expected costs, “poorer” top management should be doing the most illegal insider trading. This is because the “poor” have less to lose (present value of foregone future compensation if caught is lower for them.) We find in the data, however, that indictments are concentrated in the “richer” strata after we control for firm size, industry, firm growth opportunities, executive age, the opportunity to commit illegal insider trading, and the possibility that regulators target the “richer” strata. We thus rule out the economic motive for this white-collar crime, and leave open the possibility of other motives.

One hypothesis:  the need for more money is not necessarily perfectly correlated with how much you have.  Insider traders are rich because they really want to be rich (some would call this “greed”). The higher demand for money offsets the risks. This doesn’t mean you can “rule out the economic motive” for insider trading. 

There may be broader implications here for executive compensation, executive misconduct generally, and for reconciling this data with evidence of executives’ willingness to trade off insider trading and other compensation.

CBS is all hot and bothered about insider trading by Congress.  Steve Bainbridge is not so sure it’s illegal. Neither am I, and I question whether it should be on policy grounds (see here, first published here).  I suggest more disclosure, and reducing the opportunity for all kinds of corruption by having less law.

Last year I suggested that regulators would better fight corporate fraud by letting those in the know trade on the information than through the complex whistleblowing rules like those in Dodd-Frank.

Robert Wagner has similar thoughts.  The article is  Gordon Gekko to the Rescue?: Insider Trading as a Tool to Combat Accounting Fraud.  Here’s the abstract:

This Article puts forward that, counter-intuitively, one way to help avoid future accounting scandals such as WorldCom would be the legalization of “fraud-inhibiting insider trading.” Fraud-inhibiting insider trading is the subcategory of insider trading where: (1) information is present that would have a price-decreasing effect on stock if made public; (2) the traded stock belongs to an individual who will likely suffer financial injury from a subsequent stock price reduction if the trading does not take place; (3) the individual on whose behalf the trading occurs would have the ability to prevent the release of the information or to release distorted information to the public; and (4) the individual in question did not commit any fraudulent activities prior to availing himself of the safe harbor. Arguing that prohibiting all insider trading incentivizes corporate fraud, this Article begins by giving examples from recent cases in which insider trading could have been used to avoid significant harm. Next, the Article briefly discusses both the history of insider trading and the philosophical and policy arguments against it. This Article particularly focuses on the two most prominent arguments raised against insider trading: (1) that it erodes confidence in the market; and (2) that it is similar to theft and should be prosecuted accordingly. Previously unexamined empirical evidence suggests that the confidence argument may be incorrect and does not suffice to justify a prohibition on fraud-inhibiting insider trading. This Article also shows that while the property rights rationale is the strongest position against general insider trading, it is an insufficient basis to outlaw fraud-inhibiting insider trading. The Article concludes with a proposal that the courts, the Securities and Exchange Commission, or Congress enact a safe harbor to legalize fraud-inhibiting insider trading and thus enable the insider trading laws to more effectively achieve their purported goal of protecting the securities market and investors.

Amid yesterday’s market turmoil it’s easy to forget about Rajat Gupta.  He’s the guy whose suit against the SEC led a federal judge to put the agency under judicial supervision.

Now the SEC has dismissed its misbegotten administrative proceeding. They can file a civil insider trading case before the same judge who has cast his skeptical gaze on the agency.

Steve Bainbridge responds to my post about insider trading as compensation with a suggestion that rules against insider trading are an example of a case “where mandatory rules are appropriate.”

I was about to sputter about laws against insider trading are really about property rights, and surely property should be alienable — right?  And about how this is really about fiduciary duties, and behind that agency costs, which is the heart of corporate law.  So how much of the rest of corporate law should be made mandatory and federal?

Then I realized Steve was really talking about lawyers trading on clients’ information.  Well, that’s different. Clients rarely authorize this, so it’s usually theft and therefore bad.  But I still wonder why clients shouldn’t be allowed to authorize it.  And who knows whether that might happen as lawyers’ roles evolve?  (You knew I was going to stick that one in again, didn’t you?)

But after calming down I got riled up by the last line: “If investors have a taste for prohibiting insider trading, it thus does no good to say that the world would be a more efficient place if insider trading were allowed.”

Um, well, where does that sort of reasoning stop?  People ought to be able to indulge a lot of seemingly goofy tastes.  But that’s a long way from a normative argument that these tastes should be imposed on society.