R. Foster Winans knows insider trading.
A former author of the Wall Street Journal‘s Heard on the Street column, Winans was a key figure in an insider trading case that went all the way to the U.S. Supreme Court. In that case, Carpenter v. United States, the Court affirmed securities fraud and mail/wire fraud convictions against Winans, who tipped investors about the contents of forthcoming Heard on the Street columns.
In an interesting NYT op-ed, Winans argues for a rethinking of insider trading policy. He contends that the SEC’s current policy improperly aims at “maintain[ing] fairness” in securities markets. Trading on an informational advantage may be a sin, Winans says, but it really isn’t a crime. Indeed, everyone who trades stock does so because she believes she knows something others don’t — something that causes the stock she’s trading to be undervalued (if she’s purchasing) or overvalued (if she’s selling). Moreover, the only way the SEC can police unfair trading on the basis of an informational advantage is to prosecute selectively, “much as a patrolman tickets only the red sports car when everyone on the road is speeding.” That sort of selective prosecution is troubling, Winans maintains, for “stopping the sports car slows traffic only for a mile or two” and “gives the false impression that the policeman is on the beat, making the financial markets safe for the rest of us.”
Winans thus concludes that the SEC ought to stop fighting sin — i.e., trading on an informational advantage — and redirect its efforts to combatting crime — i.e., insider trading that involves the theft of non-public information. (“The solution is sinfully simple. Throw out the current insider trading laws and bus the Securities and Exchange Commission’s lawyers over to the Justice Department, where they can concentrate on the real crime: stealing.”)
While I’m generally sympathetic, I think Winans glosses over a couple of things.
First, current insider trading policy is not — at least, isn’t officially — based on the achievement of fairness (or a level playing field) in securities trading. It couldn’t be. As Winans notes, practically all trades involve some sort of information asymmetry. Moreover, making it illegal to trade on the basis of an informational advantage would wreak havoc on the securities industry, in which analysts make their livings — and enhance market efficiency — by discovering hidden information and recommending trades on the basis of it. Efficient capital markets are ultimately the best investor protection there is, so any development that impaired securities analysts would ultimately harm investors.
Fortunately, the Supreme Court grasps this point. The Second Circuit flirted with a level playing field-based insider trading regime in the 1969 Texas Gulf Sulphur case (“The core of Rule 10b-5 is the implementation of the Congressional purpose that all investors should have equal access to the rewards of participation in securities transactions. … The insiders here were not trading on an equal footing with the outside investors.”). The Supreme Court, however, squarely rejected the notion that insider trading liability can arise solely because of the unfairness of trading on an informational advantage:
Imposing a duty to disclose or abstain solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market. (Dirks v. SEC, 1983)
Now, Winans may be right that the SEC’s real goal in prosecuting insider trading is to create some sort of level playing field. As a matter of legal doctrine, though, the insider trading ban is not based on ensuring informational parity. In other words, “sinful” trading on an informational advantage is not, without more, illegal.
Second, Winans’ sin versus crime dichotomy is a false one, for it leaves out the actual theory on which the ban is based: fraud. As a matter of official doctrine, insider trading is illegal not because it’s unfair (the sin theory) or because it’s stealing (the crime theory) but because it involves a misrepresentation. Under the classical theory, fraud arises because the trader is a fiduciary of her trading partner, owes that partner a duty to disclose the inside information before trading on it, and fails to do so. Under the misappropriation theory, fraud arises because the trader is in a relationship of trust or confidence with the source of her information and “feigns fidelity to the source of the information” by failing to disclose her trading plans before doing so. (See United States v. O’Hagan, 1997). While the misappropriation theory does seem to involve some sort of stealing (using information owned by a fiduciary), liability is based not on the using of the information but on the failure to disclose one’s intention to do so. As Justice Ginsburg explained in O’Hagan, “[F]ull disclosure forecloses liability under the misappropriation theory … [I]f the fiduciary discloses to the source that he plans to trade on the nonpublic information, there is no [insider trading liability].”
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All that said, I’m sympathetic to Winans’ basic point that we should reconceive of insider trading as an offense based on theft, not fraud. The gravamen of an insider trading offense is trading on information that doesn’t belong to you, and the only reason the courts have concocted this crazy fraud-based liability scheme (which Saikrishna Prakash has aptly described as dysfunctional) is because the securities laws ban fraud and not theft of information. Congress could easily fix that and would likely do so if the courts would ever own up to the fact that they just can’t force this square peg of theft into the round hole of fraud.
Of course, if insider trading were treated as a property rights violation rather than as fraud, the door would be open for firms to opt out of the insider trading ban. A corporation might say to its insiders (or to some class of them), “We transfer our right to this information to you. You may use this information in making trades.” Would firms really do that? Who knows. We could let the market decide. Firms might find, as Henry Manne famously argued, that the right to trade on inside information is a desirable form of compensation — that their shareholders are better off if executives are compensated with the right to use information rather than with money that could otherwise go to the shareholders. Or they might find, as I’ve argued, that the right to trade on inside information enhances the efficiency of the firm’s stock price, preventing mispricing that can increase agency costs. Or they might find, as Henry more recently argued, that insider trading provides informational benefits that lead to better management.
It’s impossible to say ex ante what firms would do if we allowed them to allocate the right to trade on inside information. It’s likely, though, that some firms would figure out ways to reallocate property rights to enhance shareholder value. I say we take Winans’ advice, reconceive of insider trading as a property rights issue, and see what the market produces.