Archives For 10b-5

I share Alden’s disappointment that the Supreme Court did not overrule Basic v. Levinson in Monday’s Halliburton decision.  I’m also surprised by the Court’s ruling.  As I explained in this lengthy post, I expected the Court to alter Basic to require Rule 10b-5 plaintiffs to prove that the complained of misrepresentation occasioned a price effect.  Instead, the Court maintained Basic’s rule that price impact is presumed if the plaintiff proves that the misinformation was public and material and that “the stock traded in an efficient market.”

An upshot of Monday’s decision is that courts adjudicating Rule 10b-5 class actions will continue to face at the outset not the fairly simple question of whether the misstatement at issue moved the relevant stock’s price but instead whether that stock was traded in an “efficient market.”  Focusing on market efficiency—rather than on price impact, ultimately the key question—raises practical difficulties and creates a bit of a paradox.

First, the practical difficulties.  How is a court to know whether the market in which a security is traded is “efficient” (or, given that market efficiency is not a binary matter, “efficient enough”)?  Chief Justice Roberts’ majority opinion suggested this is a simple inquiry, but it’s not.  Courts typically consider a number of factors to assess market efficiency.  According to one famous district court decision (Cammer), the relevant factors are: “(1) the stock’s average weekly trading volume; (2) the number of securities analysts that followed and reported on the stock; (3) the presence of market makers and arbitrageurs; (4) the company’s eligibility to file a Form S-3 Registration Statement; and (5) a cause-and-effect relationship, over time, between unexpected corporate events or financial releases and an immediate response in stock price.”  In re Securities Litig., 430 F.3d 503 (2005).  Other courts have supplemented these Cammer factors with a few others: market capitalization, the bid/ask spread, float, and analyses of autocorrelation.  No one can say, though, how each factor should be assessed (e.g., How many securities analysts must follow the stock? How much autocorrelation is permissible?  How large may the bid-ask spread be?).  Nor is there guidance on how to balance factors when some weigh in favor of efficiency and others don’t.  It’s a crapshoot.

In addition, focusing at the outset on whether the market at issue is efficient creates a market definition paradox in Rule 10b-5 actions.  When courts assess whether the market for a company’s stock is efficient, they assume that “the market” consists of trades in that company’s stock.  This is apparent from the Cammer (and supplementary) factors, all of which are company-specific.  It’s also implicit in portions of the Halliburton majority opinion, such as the observation that the plaintiff “submitted an event study of vari­ous episodes that might have been expected to affect the price of Halliburton’s stock, in order to demonstrate that the market for that stock takes account of material, public information about the company.”  (Emphasis added.)

But the semi-strong version of the Efficient Capital Markets Hypothesis (ECMH), the economic theorem upon which Basic rests, rejects the notion that there is a “market” for a single company’s stock.  Both the semi-strong ECMH and Basic reason that public misinformation is quickly incorporated into the price of securities traded on public exchanges.  Private misinformation, by contrast, usually is not – even when such misinformation results in large trades that significantly alter the quantity demanded or quantity supplied of the relevant stock.  The reason private misinformation is not taken to affect a security’s price, even when it results in substantial changes in quantities demanded or supplied, is because the relevant market is not the stock of that particular company but is instead the universe of stocks offering a similar package of risk and reward.  Because a private misinformation-induced increase in demand for a single company’s stock – even if large relative to the  number of shares outstanding – is likely to be tiny compared to the number of available shares of close substitutes for that company’s stock, private misinformation about a company is unlikely to be reflected in the price of the company’s stock.  Public misinformation, by contrast, affects a stock’s price because it not only changes quantities demanded and supplied but also causes investors to adjust their willingness-to-pay or willingness-to-accept.  Accordingly, both the semi-strong ECMH and Basic assume that only public misinformation can be assured to affect stock prices.  That’s why, as the Halliburton majority observes, there is a presumption of price effect only if the plaintiff proves public misinformation, materiality, and an efficient market.  (For a nice explanation of this idea in the context of a real case, see Judge Easterbrook’s opinion in West v. Prudential Securities.)

The paradox, then, is that Basic and the semi-strong ECMH, in requiring public misinformation, assume that the relevant market is not company specific.  But for purposes of determining whether the “market” is efficient, the market is assumed to consist of trades of a single company’s stock.

The Supreme Court could have avoided both the practical difficulties in assessing market efficiency and the theoretical paradox identified herein had it altered Basic to require plaintiffs to establish not an efficient market but an actual price impact. Alas.

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.)

On Wednesday, the U.S. Supreme Court heard oral argument in Halliburton v. Erica P. John Fund, a case that could drastically alter the securities fraud landscape.  Here are a few thoughts on the issues at stake in the case and a cautious prediction about how the Court will rule.

First, some quick background for the uninitiated.  The broadest anti-fraud provision of the securities laws, Section 10(b) of the 1934 Securities Exchange Act, forbids the use of “any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [Securities and Exchange] Commission may prescribe….”  The Commission’s Rule 10b-5, then, makes it illegal “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.”

Although Section 10(b) doesn’t expressly entitle victims of securities fraud to sue for damages, the Supreme Court long ago inferred a private right of action to enforce the provision.  The elements of that judicially created private right of action are: (1) a material misrepresentation or omission by the defendant, (2) scienter (i.e., mental culpability worse than mere negligence) on the part of the defendant, (3) a connection between the misrepresentation or omission and the purchase or sale of a security, (4) the plaintiff’s reliance upon the misrepresentation or omission, (5) economic loss by the plaintiff, and (6) loss causation (i.e., the fraud, followed by revelation of the truth, was the proximate cause of the plaintiff’s investment loss).

For most individual investors, the economic loss resulting from any instance of securities fraud (and, thus, the potential recovery) is not enough to justify the costs of bringing a lawsuit.  Accordingly, 10b-5 suits seem like an appropriate context for class actions.  The elements of the judicially created cause of action, however, make class certification difficult.  That is because most securities fraud class actions would proceed under Federal Rule of Civil Procedure 23(b)(3), which requires that common issues of law or fact in all the plaintiffs’ cases predominate over plaintiff-specific issues.  Because the degree to which any individual investor relied upon a misrepresentation (element 4) requires proof of lots of investor-specific facts (How did you learn of the misrepresentation?, How did it influence your investment decision?, etc.), the reliance element would seem to preclude Rule 10b-5 class actions.

In Basic v. Levinson, a 1988 Supreme Court decision from which three justices were recused, a four-justice majority endorsed a doctrine that has permitted Rule 10b-5 class actions to proceed, despite the reliance element.  The so-called “fraud on the market” doctrine creates a rebuttable presumption that an investor who traded in an efficient stock market following a fraudulent disclosure (but before the truth was revealed) “relied” on that disclosure, even if she didn’t see or hear about it.  The theoretical basis for the fraud on the market doctrine is the semi-strong version of the Efficient Capital Markets Hypothesis (ECMH), which posits that securities prices almost instantly incorporate all publicly available information about the underlying company, making it impossible to earn above-normal returns by engaging in “fundamental analysis” (i.e., study of publicly available information about a listed company).  The logic of the fraud on the market doctrine is that publicly available misinformation affects a security’s price, upon which an investor normally relies when she makes her investment decision.  Thus, any investor who makes her investment decision on the basis of the stock’s price “relies” on the “ingredients” of that price, including the misinformation at issue.

In light of this logic, the Basic Court reasoned that a defendant could rebut the presumption of reliance by severing either the link between the misinformation and the stock’s price or the link between the stock’s price and the investor’s decision.  To sever the former link, the defendant would need to show that key market makers were privy to the truth, so that the complained of lie could not have affected the market price of the stock (in other words, there was “truth on the market”…great name for a blog, no?).  To sever the latter link, the defendant would need to show that the plaintiff investor made her investment decision for some reason unrelated to the stock’s price—say, because she needed to divest herself of the stock for political reasons.

Basic thus set up a scheme in which the class plaintiff bears the burden of establishing that the stock at issue traded in an efficient market.  If she does so, her (and similarly situated class members’) reliance on the misinformation at issue is presumed.  The defendant then bears the burden of rebutting the presumption by showing either that the misrepresentation did not give rise to a price distortion (probably because the truth was on the market) or that the individual investor would have traded even if she knew the statement was false (i.e., her decision was not based on the stock’s price).

The Halliburton appeal presents two questions.  First, should the Court overrule Basic and jettison the rebuttable presumption of reliance when the stock at issue is traded in an efficient market.  Second, at the class certification stage, should the defendant be permitted to prevent the reliance presumption from arising by presenting evidence that the alleged misrepresentation failed to distort the market price of the stock at issue.

With respect to the first question, the Court could go three ways.  First, it could maintain the status quo rule that 10b-5 plaintiffs, in order to obtain the reliance presumption, must establish only that the stock at issue was traded in an efficient market.  Second, it could overrule Basic wholesale and hold that a 10b-5 plaintiff must establish actual, individualized reliance (i.e., show that she knew of the misrepresentation and that it influenced her investment decision).  Third, the Court could tweak Basic by holding that plaintiffs may avail themselves of the presumption of reliance only if they establish, at the class certification stage, that the complained of
misrepresentation actually distorted the market price of the stock at issue.

My guess, which I held before oral argument and seems consistent with the justices’ questioning on Wednesday, is that the Court will take the third route.  There are serious problems with the status quo.  First, it rests squarely upon the semi-strong version of the ECMH, which has come under fire in recent years.  While no one doubts that securities prices generally incorporate publicly available information, and very quickly, a number of studies purporting to document the existence of arbitrage opportunities have challenged the empirical claim that every bit of publicly available information is immediately incorporated into the price of every security traded in an efficient market.  Indeed, the winners of this year’s Nobel Prize in Economics split on this very question.   I doubt this Supreme Court will want to be perceived as endorsing a controversial economic theory, especially when doing so isn’t necessary to maintain some sort of reliance presumption (given the third possible holding discussed above).

A second problem with the status quo is that it places an unreasonable burden on courts deciding whether to certify a class.  The threshold question for the fraud on the market presumption—is the security traded in an efficient market?—is just too difficult for non-specialist courts.  How does one identify an “efficient market”?  One court said the relevant factors are:  “(1) the stock’s average weekly trading volume; (2) the number of securities analysts that followed and reported on the stock; (3) the presence of market makers and arbitrageurs; (4) the company’s eligibility to file a Form S-3 Registration Statement; and (5) a cause-and-effect relationship, over time, between unexpected corporate events or financial releases and an immediate response in stock price.”  Others have supplemented these so-called “Cammer factors” with a few others: market capitalization, the bid/ask spread, float, and analyses of autocorrelation.  No one can say, though, how each factor should be assessed (e.g., How many securities analysts must follow the stock? How much autocorrelation is permissible?  How large may the bid-ask spread be?).  Nor is there guidance on how to balance factors when some weigh in favor of efficiency and others don’t.  It’s a crapshoot.

The status quo approach of presuming investor reliance if the plaintiff establishes an efficient market for the company’s stock is also troubling because the notion of a “market” for any single company’s stock is theoretically unsound.  An economic market consist of all products that are, from a buyer’s perspective, reasonably interchangeable.  For example, Evian bottled water (spring water from the Alps) is a very close substitute for Fiji water (spring water from the Fiji Islands) and is probably in the same product market.  From an investor’s perspective, there are scores of close substitutes for the stock of any particular company.  Such substitutes would include all other stocks that offer the same package of financial attributes (risk, expected return, etc.).  It makes little sense, then, to speak of a “market” consisting of a single company’s stock, and basing the presumption of reliance on establishment of an “efficient market” in one company’s stock is somewhat nonsensical.

With respect to the second possible route for the Halliburton Court—overturning Basic in its entirety and requiring individualized proof of actual reliance—proponents emphasize that the private right of action to enforce Section 10(b) and Rule 10b-5 is judicially created.  The Supreme Court now disfavors implied rights of action and, to avoid stepping on Congress’s turf, requires that they stick close to the statute at issue.  In particular, the Court has said that determining the elements of a private right of action requires “historical reconstruction.”  With respect to the Rule 10b-5 action, the Court tries “to infer how the 1934 Congress would have addressed the issue had the 10b-5 action been included as an express provision of the 1934 Act,” and to do that, it consults “the express causes of action” in the Act and borrows from the “most analogous” one.  In this case, that provision is Section 18(a), which is the only provision in the Exchange Act authorizing damages actions for misrepresentations affecting secondary, aftermarket trading (i.e., trading after a public offering of the stock at issue).  Section 18(a) requires a plaintiff to establish actual “eyeball” reliance—i.e., that she bought the security with knowledge of the false statement and relied upon it in making her investment decision.  There is thus a powerful legal argument in favor of a full-scale overturning of Basic.

As much as I’d like for the Court to take that route (because I believe Rule 10b-5 class actions create far greater social cost than benefit), I don’t think the Court will go there.  Overruling Basic to require eyeball reliance in Rule 10b-5 actions would be perceived as an activist, “pro-business” decision:  activist because Congress has enacted significant legislation addressing Rule 10b-5 actions and has left the fraud on the market doctrine untouched, and pro-business because it would insulate corporate managers from 10b-5 class actions.

Now, both of those characterizations are wrong.  The chief post-Basic legislation involving Rule 10b-5, the 1995 Private Securities Litigation Reform Act, specifically stated (in Section 203) that “[n]othing in this Act shall be deemed to … ratify any implied private right of action.”  As Justices Alito and Scalia emphasized at oral argument, the PSLRA expressly declined to put a congressional imprimatur on the judicially created Rule 10b-5 cause of action, so a Court decision modifying Rule 10b-5’s elements would hardly be “activist.” Nor would the decision be “pro-business” and “anti-investor.”  The fact is, the vast majority of Rule 10b-5 class actions are settled on terms where the corporation pays the bulk of the settlement, which largely goes to class counsel.  The corporation, of course, is spending investors’ money.  All told, then, investors as a class pay a lot for, and get very little from, Rule 10b-5 class actions.  A ruling eviscerating such actions would better be characterized as pro-investor.

Sadly, our financially illiterate news media cannot be expected to understand all this and would, if Basic were overturned, fill the newsstands and airwaves with familiar stories of how the Roberts Court continues on its activist, pro-business rampage.  And even more sadly, at least one key justice whose vote would be needed for a Basic overruling, has proven himself to be exceedingly concerned with avoiding the appearance of “activism.”  A wholesale overruling of Basic, then, is unlikely.

That leaves the third route, modifying Basic to require that class plaintiffs first establish a price distortion resulting from the complained of misrepresentation.  I have long suspected that this is where the Court will go, and the justices’ questioning on Wednesday suggests this is how many (especially Chief Justice Roberts and Justice Kennedy) are leaning.  From the Court’s perspective, there are several benefits to this approach.

First, it would allow the Court to avoid passing judgment on the semi-strong ECMH.  The status quo approach—prove an efficient market and we’ll presume reliance because of an inevitable price effect—really seems to endorse the semi-strong ECMH.  An approach requiring proof of price distortion, by contrast, doesn’t.  It may implicitly assume that most pieces of public information are instantly incorporated into securities prices, but no one really doubts that.

Second, the third route would substitute a fairly manageable inquiry (Did the misrepresentation occasion a price effect?) for one that is both difficult and theoretically problematic (Is the market for the company’s stock efficient?).

Third, the approach would allow the Court to eliminate a number of the most meritless securities fraud class actions without appearing overly “activist” and “pro-business.”  If class plaintiffs can’t show a price effect from a complained of misrepresentation or omission, then their claim is really frivolous and ought to go away immediately.  The status quo would permit certification of the class, despite the absence of a price effect, as long as class counsel could demonstrate an efficient market using the amorphous and unreliable factors set forth above.  And once the class is certified, the plaintiffs have tons of settlement leverage, even when they don’t have much of a claim.  In short, the price distortion criterion is a far better screen than the market efficiency screen courts currently utilize.  For all these reasons, I suspect the Court will decide not to overrule Basic but to tweak it to require a threshold showing of price distortion.

If it does so, then the second question at issue in Halliburton—may the defendant, at the class certification stage, present evidence of an absence of price distortion?—goes away.  If the plaintiff must establish price distortion to attain class certification, then due process would require that the defendant be allowed to poke holes in the plaintiff’s certification case.

So that’s my prediction on Halliburton.  We shall see.  Whatever the outcome, we’ll have lots to discuss in June.

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.

Janus Investment Fund’s (JIF) prospectus included a misstatement about market timing.  Its investment adviser and administrator is Janus Capital Management (JCM).  Plaintiff shareholders in the parent company, Janus Capital Group (JCG) argue in the Supreme Court that JCM should be liable as JIF’s manager for “mak[ing] an[] untrue statement of a material fact” in violation of Rule 10b-5 (and also that JCG should be liable as a control person).

The conservative five-member majority, in an opinion by Justice Thomas, rejected the argument that an investment advisor is the “maker” of the statement by its mutual fund, whose formal legal independence everybody including the SEC recognized.

The dissenters insist this ignores the reality of JCM’s control of JIF, and was not compelled by the word “make” in 10b-5. Moreover, they worried the majority’s approach could leave nobody responsible in some situations — not the managers who actually drafted a false statement nor the innocent board that made the statement.  Even the SEC couldn’t go after the managers for aiding and abetting without a primary violator.    

What’s really happening here is that the Court is facing the consequences of its 2008 Stoneridge aiding and abetting opinion and Central Bank which preceded it, as well as of the mess of mutual fund regulation left unresolved by last term’s Jones v. Harris.

The Court said its decision followed from Stoneridge’s holding denying liability of the defendant customers and suppliers because their acts didn’t make it “necessary and inevitable” that the transactions would be falsely accounted for.  In other words, the final decision was made by the company that actually made the decision to issue the disclosure documents.  Same in Janus.

The Court also noted its decision was made necessary by the decision Stoneridge elaborated on, the Court’s 1994 ruling in Central Bank to deny a private right of action against aiders and abetters:

A broader reading of “make,” including persons or entities without ultimate control over the content of a statement, would substantially undermine Central Bank. If persons or entities without control over the content of a statement could be considered primary violators who “made” the statement, then aiders and abettors would be almost nonexistent.6

6 The dissent correctly notes that Central Bank involved secondary, not primary, liability. Post, at 4 (opinion of BREYER, J.). But for Central Bank to have any meaning, there must be some   distinction between those who are primarily liable (and thus may be pursued in private suits) and those who are secondarily liable (and thus may not be pursued in private suits).

We draw a clean line between the two—the maker is the person or entity with ultimate authority over a statement and others are not. In contrast, the dissent’s only limit on primary liability is not much of a limit at all. It would allow for primary liability whenever “[t]he specific relationships alleged . . . warrant [that] conclusion”—whatever that may mean. Post, at 11.

Indeed, as I commented at the time Stoneridge was decided (and as Justice Thomas acknowledged in n. 7 of yesterday’s opinion), that case’s unsatisfactory resolution made Janus necessary.  I noted that, instead of focusing on the reliance requirement, the Court should have considered “precisely what conduct gives rise to a 10b-5 cause of action, and how that conduct must be connected to the deception of investors. * * * It’s not clear how th[e] “necessary or inevitable” standard will be applied in subsequent cases.”

Unfortunately, even after Janus, we still don’t know.   William Birdthistle decries the victory of “nice legal formalities” and worries that this will “tend to encourage highly strategic behavior in future.”  More likely, the Court will now find it necessary where to draw the line on strategic legal separation as a device for avoiding 10b-5 liability.

Janus actually didn’t squarely present that problem, because the formal separation the Court relied on was baked into the law of mutual funds.  This law decrees that mutual funds should have a corporate-type legal structure, complete with a board that does little of importance, despite the fact that such a structure is inconsistent with the nature of an open-end mutual fund. As I have written, this problem gave rise to Jones v. Harris, and only Congress and not the Supreme Court can solve it.

Nor can the Court solve the Central Bank-Stoneridge-Janus aiding and abetting problem.  This comes from trying to trim the judicial oak that has grown out of the little acorn in Section 10(b) of the 1934 Act.  For years the Court let the tree grow, and then for years after a different Court has visited it every several years and tried to prune it.  The Court now essentially must choose between letting it grow wild, as Justice Breyer’s dissent in Janus would do, or rely on artificial over-formal distinctions like the one in Justice Thomas’s opinion. 

The only real solution is for Congress to cut the damn thing down and disimply a private remedy under 10(b).  Since that won’t happen either, I suppose we should just sit back and enjoy the spectacle.

In Erica P. John Fund vs. Halliburton the Court held that the Fifth Circuit erred when it required loss causation for class certification.  The Court taught the lower courts the distinction among various elements of securities cases.  In order to get Basic’s presumption of reliance you have to prove, e.g.,

that the alleged misrepresentations were publicly known (else how would the market take them into account?), that the stock traded in an efficient market, and that the relevant transaction took place “between the time the misrepresentations were made and the time the truth was revealed.” Basic, 485 U. S., at 248, n. 27; id., at 241–247; see also Stoneridge, supra, at 159.

But the Court said that you don’t have to prove, as the Fifth Circuit put it

that the decline in Halliburton’s stock was “because of the correction to a prior misleading statement” and “that the subsequent loss could not otherwise be explained by some additional factors revealed then to the market.” Id., at 336 (emphasis deleted).

This is “loss causation,” an element of the plaintiff’s case, often dealt with on motion for summary judgment.

For an analysis of loss causation in the context of the other elements of a 10b-5 case, see my Fraud on a Noisy Market.

Dan Fisher correctly notes that “the U.S. Supreme Court once again confounded critics who accuse it of a pro-business bias.”

But I don’t necessarily agree with him that “[t]he decision reaffirms the entire court’s approval of securities class actions as a method of compensating investors for stock-market losses.”  Nothing fundamental has changed since the Court tightened the loss causation requirement in Dura Pharmaceuticals or limited the foreign reach of the securities laws in Morrison vs. National Australia Bank.  All the Court did is discipline a misapplication of doctrine.  Any more basic fix here will have to be up to Congress.

Henry G. Manne is Dean Emeritus of the George Mason University School of Law and Distinguished Visiting Professor at the Ave Maria School of Law.

The SEC is at it again, scandal mongering insider trading.  As usual this is the “biggest insider trading case yet,” as if they were trying for some Guinness record.  Since this story will be in the financial press for months and months to come, the well informed spectator – or participant – will want to understand that a lot of what is thought to be known about insider trading “ain’t necessarily so.”

1) Insider trading injures the stock traders who buy from or sell to the insider.

False: these outsiders are voluntarily transacting in an anonymous stock market and would be there and make or lose about the same amount regardless of the identity of the other party.

2) Legalizing insider trading would cause a great loss of confidence in the integrity of the stock market and thereby reduce capital investment, liquidity and trading.

False: Empirical studies strongly contradict this, and a robust stock market in the United States before the late 1960’s (when serious enforcement began) or in the rest of the world today (where serious enforcement has yet to begin) denies this.

3) Sensible enforcement of insider trading laws is feasible.

False: the ever larger, politically inspired, and inevitably unproductive SEC campaigns against insider trading demonstrate that significant enforcement is not only difficult, it is practically impossible.  And this is to say nothing of the logical impossibility of policing gains made by an insider’s knowing when not to buy or sell, a purely mental transaction that can never be policed.

4)  The SEC’s high-tech detection methods uncover illicit trading.

False: This claim has been made by the SEC from the beginning and is apparently not much more true today than it was fifty years ago.  Use of informants and wire tapping are the methods by which the SEC does most of its policing.

5)  There are no net social or economic costs to partial enforcement of these laws.

False:  The individuals who might be desirably motivated in their work by the right to trade on inside information are displaced (because they are so easily spotted and targeted by the SEC) by individuals with no claim to the value of the information but who are more difficult to identify and convict.

6)  We need regulation since the corporation itself has a property right in the information it produces, and the government can better protect this right than can the individual corporations.

False:  If the corporation had a real property right, then it could opt out of the regulation and allow its insiders to trade, something the SEC has steadfastly resisted.  And even if the government could enforce the rule more efficiently (highly dubious), there is no justification for this subsidy to certain companies.  (Even Steve Bainbridge gets this one wrong.)

7)  Insider trading does not contribute to the efficiency of stock market pricing.

False:  All trading has some marginal effect on price, and by definition any informed trading pushes the price in the correct direction, some of it quite noticeably and very quickly.  There are conflicting findings in the empirical literature on the strength of the short-term price effect of insider trading. But this probably reflects  differences in the pricing process resulting from varying trading and market conditions.  Further, nearly all empirical studies in this field are based on data representing legal and reported insider trading, a decidedly inappropriate way to measure the effect of illegal insider trading.

8)  If insiders are trading, market makers will have to broaden their bid-ask spreads and thus charge more to all traders.

False:  Careful research on this point concludes that market makers on stock exchanges do not feel harmed by the presence of insiders in the market and do not adjust their spreads in response.

9)  There is a clear definition of “insider trading” and of the level of “materiality” required for a violation of the law.

False:  Neither the SEC nor Congress has ever defined “inside information”, nor has either succeeded in specifying the level of significance the information must have to be the subject of a criminal violation.

10)  It is easy to distinguish the information insiders use illegally from that analysts secure in the legitimate course of their work.

False:  This line is so grey and the potential rewards so great that the line is easily and regularly overstepped, either inadvertently or intentionally.  The present prosecution is apparently based to some extent on the notion that assembling many small pieces of non-material information into a single “mosaic” of valuable information is illegal. Just what is it that the SEC wants analysts to do?

11)  Allowing trading on bad news as well as on good will create an incentive for executives to create bad news.

False:  All the motivating vectors in the market for managers point them in the direction of trying to increase their company’s stock price not lower it, and these pressures would overwhelm any slight increase in adverse motivation from insider trading.

12)  The criminalization of insider trading has no effect on the compensation of corporate employees.

False: Recent research demonstrates that when the right to trade on information is denied to executives, they must be paid additional compensating sums to substitute for this loss.  This must partially account for the enormous increases in executive salaries, bonuses and stock options we have witnessed in the past thirty years.

13)  Individuals within the company who were not responsible for the good news may profit from the knowledge and, therefore, insider trading serves no valuable reward function.

False: While it is very difficult to design an efficient compensation scheme to encourage innovation, allowing insider trading by everyone aware of new developments will create a corporate culture of innovation and risk taking without requiring the enormous option plans and bonuses currently used, which incidentally, and unlike insider trading, come out of the shareholders’ pockets.

14)  The SEC has studied the economics of insider trading and applied rigorous economic analysis to the phenomenon.

False:  If they have, they have certainly failed to disclose this significant bit of information to the public or to make any intellectual sophistication apparent.

15)  Fuzzy notions of fairness have a place in serious discussions of the economic costs and benefits of regulation.


Lynn Stout, writing in the Harvard Business Review’s blog, claims that hedge funds are uniquely “criminogenic” environments.  (Not surprisingly, Frank Pasquale seems reflexively to approve):

My research, shows that people’s circumstances affect whether they are likely to act prosocially. And some hedge funds provided the circumstances for encouraging an antisocial behavior like not obeying the laws against insider trading, according to these investigations.

* * *

Recognizing that some hedge funds present social environments that encourage unethical behavior allows us to identify new and better ways to address the perennial problem of insider trading. For example, because traders listen to instructions from their managers and investors, insider trading would be less of a problem if those managers and investors could be given greater incentive to urge their own traders to comply with the law, perhaps by holding the managers and investors — not just the individual traders — accountable for insider trading. Similarly, because traders mimic the behavior of other traders, devoting the enforcement resources necessary to discover and remove any “bad apples” before they spoil the rest of the barrel is essential; if the current round of investigations leads to convictions, it is likely to have a substantial impact on trader behavior, at least for a while. Finally, insider trading will be easier to deter if we combat the common but mistaken perception that it is a “victimless” crime.

Rather than re-post the whole article, I’ll direct you there to see why she thinks hedge funds are so uniquely anti-social.  Then I urge you to ask yourself whether she has actually demonstrated anything of the sort.  Really what she demonstrates, if anything, is that agency costs exist.  Oh, and people learn from their peers.  Remarkable!  And this is different than . . . the rest of the world, how?  There are Jewish people in the world, a lot of them work on Wall Street, and many of them attend synagogue.  No doubt Jews mimic the behavior of other Jews.  Bernie Madoff was Jewish.  The SEC should be raiding temples all across New York, New Jersey and Connecticut!

The point is that she has no point, and directing her pointless observations toward hedge funds in particular is just silly (and/or politically expedient).  There are bad apples everywhere.  There are agency costs everywhere.  A police state could probably reduce the consequences of these problems (but don’t forget corruption (i.e., bad apples) in the government!).  The question is whether it’s worth it, and that requires a far more subtle analysis than Stout provides here.

And all of this is because insider trading really needs to be eradicated, according to Stout:

Of course, insider trading isn’t really victimless: for every trader who reaps a gain using insider information, some investor on the other side of the trade must lose. But because the losing investor is distant and anonymous, it’s easy to mistakenly feel that insider trading isn’t really doing harm.

Actually, the reason most people feel that insider trading isn’t really doing harm is because it isn’t.

I’ll leave the synopsis of the argument to Steve Bainbridge.  On the adverse selection argument, see Stanislav Dolgopolov.  Sure, there is debate.  Empirics are hard to come by.  But the weight of the evidence and theory, especially accounting for enforcement costs (one study even seems to suggest that making insider trading illegal actually induces more insider trading to occur (and impedes M&A activity)), is decidedly against Stout’s naked assertion.  The follow on claim that, in essence, agency costs justify stepped up dawn raids at hedge funds is even more baseless.

One problem with a group blog is that you don’t always know what your co-bloggers are writing while you’re drafting a post.  I drafted the following post without realizing that Larry (and Steve Bainbridge) had already gone to town on the matter — in more detail than I, not surprisingly.  In any event, I’m posting my draft, which may be of interest to readers who aren’t as well-versed in insider trading law.  The excellent Ribstein and Bainbridge posts are here, here, and here.

The Wall Street Journal is reporting that the Feds (the SEC, the FBI, and federal prosecutors in New York) are about to bring a host of insider trading charges “that could ensnare consultants, investment bankers, hedge-fund and mutual-fund traders and analysts across the nation.”  The authorities, which have been investigating the situation for three years, are boasting that their criminal and civil probes “could eclipse the impact on the financial industry of any previous such investigation.”   

The charges haven’t been filed, so we don’t know exactly who’s being accused of what, but the Journal suggests that the probe has focused on at least three matters.  First, the Feds have examined whether traders received material, non-public information about pending merger deals.  Second, authorities have focused on the activities of independent analysts and research boutiques.  In addition, they have investigated firms that provide “expert network” services to hedge funds and mutual funds.  Such firms “set up meetings and calls with current and former managers from hundreds of companies for traders seeking an investing edge.”     

The first focus — insiders’ sharing of information about pending merger deals and tippees’ trading on the basis of such information — seems pretty uncontroversial.  As a legal matter, the insiders owe a fiduciary duty to the shareholders whose stock is being traded, and in trading that stock (or effectively enlisting an accomplice tippee to do so) without first disclosing the information at issue, the insiders are failing to speak in the presence of a duty to do so.  That’s fraud, and the tippee-traders are liable as accomplices.  While I would generally prefer an approach that permits companies to establish their own insider trading policies and leaves it to capital markets to punish the value-destructive ones and reward those that enhance value, the ban on this type of insider trading is easiest to defend as a matter of policy:  An insider or tippee who trades in advance of a merger may cause a price effect that thwarts or impairs the merger deal, thereby harming the corporation and its shareholders.  Even if we left insider trading to contract, as I would prefer, I imagine that most firms and shareholders would bargain for a policy that bans trading on the basis of non-public information about a forthcoming merger.

The second and third focuses (foci?) of the Feds’ current probe, though, are more troubling.  Again, we don’t know why the feds are currently going after independent analysts, research boutiques, and firms providing “expert network” services, but we do know that they have a long history of opposing legitimate stock analysis that gives certain traders an informational advantage over others.  In the 1968 Texas Gulf Sulphur case, for example, the SEC maintained (and convinced the Second Circuit to hold) that the mere possession of material, non-public information saddles an investor with a duty to disclose that information before trading or to refrain from trading altogether.  The Supreme Court ultimately rejected such a broad imposition of the so-called “disclose or abstain” duty, recognizing that the Texas Gulf Sulphur approach would ultimately hurt investors by disabling the securities analysis business.  Analysts, after all, make money by ferreting out material, non-public information and conferring informational advantages on their clients.  Their efforts, coupled with the trading of their informed clients, make stock markets more efficient, meaning that stock prices more accurately reflect the true value of the underlying companies.  By making stock prices more accurate, analysts help prevent uninformed investors from losing their shirts when undisclosed information shocks the market.  While I wouldn’t exactly call it the Lord’s work (not after the Lloyd Blankfein blunder, at least), securities analysis is awfully good for society and shouldn’t be discouraged.

The SEC, though, didn’t give up after its first Supreme Court smackdown.  Just three years later, the Commission went after a “tippee” (Dirks) who had shared inside information with others who traded.  The inside information concerned the fact that the corporation at issue had engaged in serious accounting fraud and was consequently overvalued.  The tippee had learned about the fraud from an insider who sought the tippee’s assistance in exposing the fraud (which, incidentally, the SEC had failed to discover on its own).  The SEC took the position that the tippee “inherited” the insider’s fiduciary duty not to trade (or tip to others who might trade) because he had received information from an insider — in other words, merely receiving non-public information from an insider essentially transforms one into an insider himself.  Again, the Supreme Court rejected the SEC’s broad liability net.  Noting again that the SEC’s rule would impair the securities analysis industry, the Court held that a tippee inherits an insider’s duty to disclose or abstain only if (1) the insider breaches his duty of loyalty in sharing the information (i.e., the insider shares the information to get a personal benefit) and (2) the tippee knows or should know of the breach.

The Supreme Court’s Dirks decision threw yet another wrench into the SEC’s campaign to put all investors on a level playing field when it comes to information (market efficiency be damned!) because it seemed to allow corporate insiders to share material, non-public information with stock analysts.  In sharing non-public information with the analysts following their firm, insiders aren’t generally seeking a personal benefit, so the test for tipping isn’t satisfied and the analysts and their clients wouldn’t inherit the insiders’ duties.  The SEC therefore responsed by promulgating Regulation FD, which requires corporate insiders who share data that could consitute material, non-public information to also share that information with the general public.  If the information-sharing is intentional, the public must be informed contemporaneously with analysts; if information is unintentionally given (i.e., a “slip-up”), the general public must be promptly informed.

That sounds fair enough, right?  Well, sure.  But that fairness comes at a cost.  Since Regulation FD was adopted, corporations have become more leery of sharing information with analysts — those folks whose efforts best protect investors by ensuring that stock prices accurately reflect underlying values.  Spontaneous analyst conversations are impossible because corporations now have to publicize calls, provide call-in information to the public, etc.   When analysts need help interpreting data, or if they have follow-up questions after an analyst conference, insiders generally won’t answer their questions.  And, of course, analysts are now less interested in participating in analyst conferences, since the information being shared (with the general public) is less valuable.  As Anup Agrawal, Sahiba Chadha, and Mark Chen have shown, the result has been a reduction in the accuracy of individual and consensus analyst forecasts on corporate performance and an increase in the dispersion among forecasts.  Again, the SEC’s attempt to put investors on a level playing field seems to have impaired one of the most effective form of investor protection out there — the sell-side analyst industry.  (NOTE:  Larry has written lots of good stuff on Reg FD.  Here‘s a link to a list of posts from Ideoblog.) 

So what to make of this latest SEC/FBI/DOJ investigation?  We won’t really know until we see the allegations.  But in light of the SEC’s relentless pursuit of the securities analysis business over the years, I’m a bit worried that the current probe is focusing largely on analysts, research boutiques, and firms providing expert network services.  We shall see….

In a front-page article entitled Congress Staffers Gain from Trading in Stocks, the Wall Street Journal reports that “72 aides on both sides of the aisle traded shares of companies that their bosses help oversee.” That finding was based on an “analysis of more than 3,000 disclosure forms covering trading activity by Capitol Hill staffers for 2008 and 2009.”

A number of the trades appear awfully suspicious. One aide to a member of the Senate Banking Committee, for example, bought Bank of America stock in mid- and late-April 2009, about the time BOA was conferring with the government over the results of Treasury’s “stress tests.” Those results were publicly disseminated on May 7, and the staffer eventually netted a 43% gain. The husband of a Pelosi aide bought around $4,700 of Fannie and Freddie stock and resold it later the same day — two days before the Fed authorized emergency funding to the two firms — for a $2,000 (43%) gain.

This could all be coincidental, of course. According to the Journal, “[t]he aides identified … say they didn’t profit by making trades based on any information gathered in the halls of Congress.” The Journal then goes on to say that “[e]ven if they had done so, it would be legal, because insider-trading laws don’t apply to Congress.”

I’m not sure about that last bit. The Journal doesn’t spell out why the aides’ trades wouldn’t run afoul of the federal insider trading prohibition, but I think it’s assuming that because members of Congress may trade on material, non-public information they learn in the course of their jobs, their aides may do so as well. I don’t think that’s right.

The securities laws treat insider trading (incorrectly, in my opinion) as a species of fraud. The statutory basis for the insider trading prohibition is Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Taken together, those provisions prohibit material misrepresentations and omissions in connection with the sale or purchase of a security. Because trading on the basis of material, non-public information usually doesn’t involve an affirmative misstatement, insider trading liability generally requires that the trader possess some duty to speak.  Failure to speak in the face of a duty to do so then constitutes an actionable omission.

The Supreme Court has recognized two situations in which a duty to speak before trading may arise. First, if the trader is a fiduciary of her trading partner (as when an insider is buying her own company’s shares), the fiduciary relationship gives rise to a duty to speak to that partner (i.e., to disclose the material, non-public information) before trading. That’s the so-called “Classical” theory of insider trading. Even where the trader is not dealing in her own company’s securities, though, she may have a duty to speak before trading if she is in a relationship of trust or confidence with the source of her material, non-public information. Thus, under the so-called “Misappropriation” theory, a trader who received the non-public information at issue from someone to whom she owes a duty of trust or confidence “feigns fidelity to the source” of that information (those are the Supreme Court’s words) if she trades without first notifying her source of her intention to do so. That’s an actionable omission that may run afoul of Rule 10b-5 and Section 10(b).

Given these rules, one can see why members of Congress would have lots of leeway to engage in insider trading.  If the member is not an insider of the company whose stock she’s trading (which will almost always be the case), the Classical theory will not apply.  Because members of Congress generally don’t owe duties of trust or confidence to the many sources from which they receive material non-public information, they would not be “feigning fidelity to the source” of such information in trading on it without first declaring their intent to do so, and the Misappropriation theory would not apply.  Thus, the current regulatory scheme leaves a hole that members of Congress could presumably exploit.  While the Stop Trading on Congressional Knowledge (“STOCK”) Act would fill those gaps, it has very few sponsors and isn’t likely to be enacted anytime soon.

But to say that current insider trading rules generally don’t reach trades by members of Congress is not to imply that congressional staffers are free to trade on material non-public information they acquire in the course of their jobs.  I’ve never worked for a member of Congress, but I assume that staffers agree to keep confidential any material information about legislative developments that might affect the prospects of listed companies.  If a staffer does make such a pledge, either explicitly or implicitly, then isn’t trading on the information “feigning fidelity to the source of the information” — i.e., the congressman for whom she works?

Am I missing something?  I confess that I know nothing about how legislators’ offices work.  If I’ve omitted something from the analysis, please enlighten.

UPDATE:  More from Professor Bainbridge here and here.  (Didn’t see his posts before drafting mine.)  I learned much of what I know about insider trading from Professor B’s fine work on the subject, so, not surprisingly, we’re making the same basic points in these posts.

We usually think about jurisdictional choice for corporate law as applying to state business association laws, not the federal securities laws.  But this distinction has never been clear given global securities markets, and it’s less true now than it used to be.

The WSJ discusses the securities bar’s and regulators’ lamentations over last summer’s Morrison v. National Australia Bank holding that that foreign plaintiffs who transacted in foreign shares on a foreign exchange (i.e., “f cubed”) could not bring a 10b-5 action.  The article notes that the ruling seems to be helping foreign-based companies like BP and Toyota that are facing investor suits over non-disclosure of risks that turned into big liabilities. It says  judges have been barring U.S. suits even by U.S. investors who bought shares on foreign exchanges (i.e., “f squared”).

Plaintiffs’ securities lawyers and some state officials are trying to get Congress to reverse the decision because, according to the article, “in a global marketplace in which U.S. capital increasingly flows into foreign stock exchanges, it is unfair to deprive U.S. investors of the protection of domestic law because they purchased stock overseas.”

But as I pointed out when the Morrison decision came down, the ruling “promotes globalized securities markets . . . by adopting a test that enables investors to choose the applicable regulation by deciding where to trade.”  In other words, investors may not want to be “protected” by U.S. law because it’s better for plaintiffs’ securities lawyers than for investors.   The exchange-based test gives investors clear notice of when they’re protected and when not.

At the same time, foreign firms can more easily choose, just by deciding which exchange to trade on, whether the extra credibility they get from the application of U.S. law is worth the extra costs.  As I’ve written, this may be less likely the case after federal laws like SOX (and now Dodd-Frank), which try to impose U.S. governance norms on foreign firms.

In other words, a true “global marketplace” depends at least in part on jurisdictional choice, and not necessarily on the application of the same law everywhere.