Today’s WSJ, in an obvious effort to grab readers seeking more insider trading titillation in the wake of the Galleon verdict, has a story about a new supposed scandal — investment banks offering hedge fund traders special access to dealmakers at exclusive lunches in order to get more trading business from the funds.

The article makes the following silly statement:

Under insider-trading laws, it is generally illegal to buy or sell securities based on “material,” or significant, information that isn’t publicly available.

No.  It’s generally legal to trade on non-public information, even if it’s material.  The exception is when the trader knows the information is obtained illegally, as the jury found in the Raj trial.  Indeed, there’s a question why a non-expert would trade in an efficient market on public information that’s presumably already in the price.

The article discusses situations that might present issues under Reg FD, which doesn’t regulate trading but restricts firms from privately disclosing non-public information without then publicly disclosing it.  But there’s no indication of illegal insider trading in connection with this meeting.  Indeed, there’s a question about how much non-public information is being disclosed.

The WSJ article aids the SEC’s project to, as I said recently, turn the molehill of illegal insider trading into a mountain that oppresses efficiency-enhancing trading.  We expect more from a top financial journal.

Rajaratnam stands convicted.  What, exactly, did he do wrong?

Holman Jenkins, writing in today’s WSJ, appropriately mocks the notion driving the Rajaratnam prosecution that insider trading “law’s purpose is to protect the public from informed stock prices.” As Jenkins notes:

There is no level playing field. Nor does there need to be one for the stock market to be an acceptable place for the public to park its savings. The efficient-markets hypothesis may not be in the best of odors these days, but its signature piece of advice is as good as ever: Stock trading is a mug’s game. Use an index fund.

On the other hand, Jenkins says, the Rajaratnam trial is properly based on the corruption by which Rajaratnam’s acquired his information: 

In the noses of any sane jury, the whiff of criminality arising from these actions would have been stronger than any forlorn assertion that investors generally were harmed by Rajaratnam’s trading.

That may be true. But it’s still the case that the seasoning of non-harm to investors with a “whiff of criminality” does not turn this bland prosecution into tasty public policy.

The wrongs that gave rise to these prosecutions were solely to the companies that owned the stolen information.  What makes this illegal insider trading, complete with Draconian criminal penalties, is that the misappropriation became the basis of stock trading, which as Jenkins says does not harm the market whether it’s based on criminality or not.  Unlike conventional securities fraud, the market is not deceived.  If anything it is enlightened by trading that helps make stock prices more accurate. 

The only deception, according to the Supreme Court in U.S. v. O’Hagan, is by the information thief to the information owner.   The federal government gets to prosecute these actions only because of a Rube Goldberg contraption by which deceiving your employer in New York into thinking you’re keeping information confidential is magically converted into fraud on a day-trader in Omaha who benefits by trading the security without realizing that its price reflects the stolen information. And of course most of us in the market aren’t affected at all because instead of foolishly day-trading we’re buying and holding index funds.   

Jenkins says the jury properly dismissed the defense’s theory that the defendant’s trades were motivated by a mosaic of legitimate information rather than by the illegal bits.  But the mosaic theory is no nuttier than the rest of this jury-rigged legal theory.  Again, Rajaratnam committed a federal crime only because the theft of information is a kind of deception, which in turn is what makes the trading illegal under present securities law.  If you steal information but don’t trade it’s not a federal crime.  If you trade on legitimately acquired non-public information it’s not a crime.  Why, then, should it be crime if you steal information but trade on other information?  

And while we’re at it, what about the other questions raised by this wacky theory and discussed in my Federalism and Insider Trading, 6 Sup. Ct. Econ. Rev. 123 (1998):  1. What kind of deception is necessary?    2. What if the information owner consented to use of its information?  3. What kind of breach of duty amounts to actionable misappropriation to justify an insider trading charge?  4. If the information owner is not harmed, does it matter if the information traded on was material to investors?  5.  If the information owner is harmed, does it matter if the information was immaterial to investors?  6.  What does materiality mean in this context?  7.  How much knowledge of all the elements of wrongdoing must the defendant have?

Let us not forget that these are criminal charges which could send Rajaratnam to jail for a very long time.  Shouldn’t we be a little clearer on exactly what he was doing wrong?  The Supreme Court ultimately may think so.

Per the WSJ, Buffett associate David Sokol bought shares of a potential Berkshire target, Lubrizol, the day after expressed interest in the company on behalf of Berkshire. He sold those shares a week later, but soon bought more around the time the Lubrizol board met to discuss Berkshire’s interest.  Sokol told Buffett about the deal and the fact that he owned Lubrizol shares a week or so later.  Buffett initially wasn’t keen on the deal, but bit ten days later. Buffett learned the details of Sokol’s purchases only after the Berkshire board offered to buy the company.

Based on these facts, Sokol may have had material information when he bought his second batch of shares: i.e., that he was going to pitch the company to Buffett.  Although he didn’t know whether Buffett would go for it, a company’s just being pitched to Buffett by a trusted insider likely increases its value. [Update:  See Sorkin: "though he had no control over Mr. Buffett’s ultimate decision, he was one of a select few who were in a position to influence such a transaction."]

But did Sokol breach a duty to Berkshire?  The company policy says employees should ask “themselves whether they are willing to have any contemplated act appear the next day on the front page of their local paper—to be read by their spouses, children and friends—with the reporting done by an informed and critical reporter.”

On the other hand, Buffett knew.  On the third hand, did Buffett know the extent of Sokol’s ownership, or the fact that he bought the shares knowing of Berkshire’s possible interest?  On the fourth hand, it seems highly unlikely Sokol thought he was doing anything wrong.

Berkshire might be hurt if Sokol had a conflict of interest in pitching the deal.  But that conflict was disclosed.  It also might be hurt by revelations of a breach of integrity by top executive, though its stock decline on the revelation is probably because of Sokol’s resignation.  

My question:  what should federal law have to do with all this?  The “hook” for federal securities liability is the trading in Lubrizol — but the breach of duty that triggers liability has to do with the details of Sokol’s dealings with Buffett and Berkshire.  This, as I’ve said before, is appropriately a matter of state law.  See my article, Federalism and Insider Trading, 6 Supreme Court Economic Review, 123 (1998).

Nevertheless, the WSJ article says SEC is investigating.  Let’s hope nobody at the SEC has stock in Berkshire.

Update:  More on Sokol’s potential insider trading liability from Bainbridge, Bradford, and Davidoff.  I’ll stick to my initial post re materiality.  Bainbridge has a point that Sokol’s disclosure of his conflict may not be exonerating on state law, as I said recently.

The SEC has civilly charged an FDA employee under 17(a) and 10(b) with violating his duty of trust and confidence to the FDA and misappropriating drug approval information by using it to make $3.6 million in trading securities. The WSJ story summarizes:

The SEC and the Justice Department said the men traded shares dating back to 2006 of companies whose drugs were used for colon cancer, schizophrenia, insomnia, severe constipation, osteoarthritis and heart disease. Some of the FDA announcements at issue involved delays in the approval process due to the drugs’ safety or efficacy tests. Mr. Liang allegedly bought stock for profit before positive announcements, bet on shares falling after negatives ones and sold shares to avoid losses. * * *

[One] of the companies whose stock he allegedly traded was Momenta Pharmaceuticals Inc., a small biotechnology company from Cambridge, Mass., which was vying with two other companies to make a generic version of the blockbuster blood thinner Lovenox. The FDA unexpectedly told the companies in November 2007 that they needed to do further testing, holding up the approval process. The SEC claimed Mr. Liang made $130,000 by trading shares a day before the news was made public, cutting Momenta’s stock nearly in half. When the drug was finally approved, in July 2010, Mr. Liang made another $85,000 buying shares three days ahead of the announcement, the SEC alleged.

Well, I suppose we should be happy somebody’s benefiting from the FDA’s unpredictable and overly careful policies.  Holman Jenkins writes today about how the FDA is toying with approving, or not, a process for spotting melanomas which could cheaply and reliably save lives.  An FDA advisory panelist said, “I believe that MelaFind is going to help a few less people die and that’s why I voted yes.” But the FDA has the final say.  And Jenkins notes that while “[m]any lives will be saved, if the FDA will let them” “nobody at the FDA is ever fired for failing to approve a device.”  But apparently some do make money from the FDA’s waffling.

Finally, Liang should be sorry he’s not a Congressman, because they can trade on political information. As I noted several years ago, the solution to this trading by government agents is to “decrease government involvement in the economy. That is, after all, the source of the insider trading problem.”  Certainly that’s true in the FDA case.