The insider trading crackdown and Reg FD

Larry Ribstein —  17 December 2010

Today’s WSJ explains how recent insider arrests cracking down on expert services are rooted in the SEC’s misguided Regulation FD. 

That rule barred firms’ employees from selectively disclosing material information to favored analysts and investors.  Selective disclosure is probably legitimate under the general insider trading laws because it’s consented to by the owner of the disclosed information rather than misappropriated.  But Arthur Levitt’s SEC thought selective disclosure encouraged analysts to bias their reports and investors to think they were playing on an unlevel playing field. 

According to the WSJ article, the expert services were “a back-door method” to replace the company as a direct information source.  In other words (surprise surprise) the rule drove a formerly legitimate activity underground, thereby making markets less transparent.

Rutgers’ Arthur Laby, once SEC assistant general counsel, told the WSJ:

Reg FD closed off an important source of information to analysts and investors, but choking the supply did not stanch the demand.  Hedge funds and other investors remain hungry for information, and this demand may well have created an alternative mechanism to supply the information to those willing to pay for it, an unintended consequence of Reg FD.

I have previously cited evidence that Reg FD reduces market efficiency. See Agrawal, Chadha and Chen, Who is Afraid of Reg FD? The Behavior and Performance of Sell-Side Analysts Following the SEC’s Fair Disclosure Rules (showing that earnings forecasts become less accurate post-FD, particularly for less-followed smaller companies).  I also wondered

who benefits from Regulation FD.  Of course:  the ordinary investor.  Which is another way of saying that we can’t let on that the market may not be a completely level playing field, because then the jerks (aka “ordinary investors”) might wise up and invest in index funds. 

Keep in mind that the long-term investor loses little or nothing from his information disadvantage.  The possible losers are the day traders sitting at their personal computers thinking they can outguess the markets with their charts.

I have also argued (SEC “Fair Disclosure” Rule is Constitutionally Suspect, 10 Washington Legal Foundation Legal Opinion Letter no. 17 (October 6, 2000), reproduced here) that Reg FD might have problems under the First Amendment. I observed that

selective disclosures to informed analysts may increase market efficiency, thereby furthering an important goal of the securities laws. Analysts can promote efficient securities pricing by combining selective disclosures with their research and analysis of the disclosing firms. Also, because of the problems * * * with publicly disclosing the same information firms give to analysts, firms that cannot selectively disclose may instead delay all disclosure and leave the market open to speculation. Indeed, selective disclosure may increase both investor confidence and efficiency because more rapid dissemination and analysis of information may reduce insider trading by corporate insiders. * * * The SEC also has attempted to justify its rule on the ground that preventing selective disclosure will encourage “fair disclosure” (i.e., “FD”). This assumes that firms will disclose publicly what they previously told analysts privately. Once again, the SEC has offered no support for this assumption. For the reasons discussed above, firms are more likely to delay all disclosure if they cannot choose their audience.

In short, Reg FD likely reduced market efficiency until expert services came along to replace the information analysts had provided.  Now the government is expending significant resources to put those services out of business.  The market as a result will be less efficient, or will find some new and less transparent way to replace the lost information.  Meanwhile the rule accomplishes nothing for ordinary investors other than suckering them into trading they shouldn’t be doing.

Good work, SEC.  Got any other bright ideas for us?  Like looking for fraud?

Larry Ribstein

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Professor of Law, University of Illinois College of Law

2 responses to The insider trading crackdown and Reg FD

  1. 

    I would like to make a couple of addendums to Larry’s superb blog on current insider trading developments. To fully understand this episode, and the SEC’s continuing fatuousness, one needs to go back to the pre-Reg. FD days. While there was no written exception to the assumed rule against insider trading for analysts, it was generally understood and even openly opined by the SEC that there was nothing illegal about a company’s making new disclosures to select analysts. This was apparently justified at the time by the incongruous argument that this was needed to get information out to the market quickly, a job that could be done effectively by analysts. Clearly the dissemination of new information was a subject that the SEC did not have a clue about either in theory or in fact, so they opted for this analyst-distribution system as a necessary supplement to the manadatory disclsure regulations. We should not overlook, in considering this pre-FD quasi-ruling, the intimations of the Macey Haddock theory that the greatest beneficiaries of insider trading bans would be those standing second in line for the information, in this case, as they theorized, the analysts. That situation continued for many years, doing nothing whatever to change the economic impact of insider trading but merely shifting the beneficiaries of the new knowledge from those who might have had some responsibility for producing it (with considerable cost savings to shareholders, as Todd Henderson ahs recently confirmed)to a group favored at that time by the SEC, the analysts. Subsequently, for reasons that I do understand though sheer ignorance is never a bad bet in the case of the SEC, the anlysts seem to have lost some clout there (to whom? perhaps the securities bar). Mr. Leavitt at the time seemed shocked, shocked to learn that the analysts were in some cases actually using the information to trade on (or passing it to preferred clients). Thus, Leavitt declared, we have to have Reg. FD to close a loophole (there is that pesky loophole again)in the insider trading laws. The consequence, of course, was to drive the information flow farther away from a welfare-enhancing equilibrium to a less effective and more opaque distribution scheme. And that is precisely what will continue to occur if the SEC succeeds in its present quixotic joust. The information will be driven even further underground into even less worthy hands and stock market pricing will be less efficient.

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