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Another Politician Wants to Ban Insider Trading

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Why is insider trading illegal? I think there are two main reasons:

  1. It is unfair: You shouldn’t trade if you have information that everybody else doesn’t have.
  2. It is theft of information: Companies own their inside information, and you shouldn’t take their information and use it for your own profit.

The first theory is far more popular but obviously wrong. Honestly you should only trade if you have information that everybody else doesn’t have. The (social) point of trading is to get information incorporated into market prices. If you have no information to incorporate into the price, you’re not doing anyone any favors by trading. Least of all yourself: If you only have the same information as everyone else, how are you going to make any money? Just index. 

The second theory is much less popular and intuitive, but it has the advantage of being more or less the law. Everyone who pays attention to insider trading knows this. The Securities and Exchange Commission says: “Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.” (My emphasis.) You need that breach of a duty to make it insider trading. Just having material nonpublic information is fine. You can trade on material nonpublic information all you want. You just can’t do it if you came by that information dishonestly, or from people who came by it dishonestly1.

One way to think about December’s Newman decision is that prosecutors had increasing success marketing the fairness theory of insider trading — to juries, and to the public — and courts finally pushed back and said, no no no, insider trading is about theft of information, not unfairness. So Todd Newman and Anthony Chiasson definitely had unfair advantages in trading securities. They ran hedge funds, they had analysts working for them, those analysts had networks of buddies and experts who fed them investment ideas, etc. They got paid millions of dollars for making trades on information that the average individual retail investor doesn’t have. Sure some of that information came from people who talked to people who talked to people inside of companies without the approval of those companies, but there wasn’t much direct evidence that Newman and Chiasson knew that.

Prosecutors argued that Newman and Chiasson knew they had unfair advantages, and for the jury that was enough.2 On appeal, though, the court said that it’s not enough to prove that insider traders had unfair advantages. Insider trading is about theft of information, either by company insiders using company information for personal gain (by trading on it or selling it to someone else who trades on it), or else by company outsiders (lawyers, accountants, newspaper columnists) who have an obligation to keep information secret and violate that obligation.

If Newman and Chiasson didn’t know the details of the relevant theft — if they didn’t have reason to know that the tippers who provided the information were doing it for a personal benefit — then they couldn’t be guilty of insider trading.

Like I said, though, the first theory is a lot more popular, so the Newman decision sparked a backlash. And, as backlashes do, this one led to bills being introduced in Congress to re-forbid insider trading.

The first of those bills, from Representative Stephen Lynch of Massachusetts, seemed to more or less follow the theft-of-information theory of insider trading, albeit a bit sloppily: It banned trading on “inside information,” but nonpublic information only counts as “inside information” if it was obtained illegally, in violation of a fiduciary duty, or from an issuer “with an expectation of confidentiality or that such information will only be used for a legitimate business purposes.3“ But the second bill, from Senators Jack Reed and Bob Menendez, was a pretty pure expression of the unfair-advantages theory of insider trading: It would ban any trading “on the basis of material information that the person knows or has reason to know is not publicly available.” We talked about it a few weeks ago, and I expressed all the obvious horror at criminalizing efforts to find out information about companies. Finding out information about companies is valuable work. People should be allowed to do it.

Here’s a third ban-insider-trading bill, introduced in Congress last week by Representative Jim Himes of Connecticut4Peter Henning says that it “goes about as far as possible to make it illegal to trade while in possession of ‘material, nonpublic information,’” but I don’t think that’s true? The Reed-Menendez bill goes as far as possible to do that, insofar as it just does that. The new Himes bill is considerably more generous to potential traders on nonpublic information. Specifically, it forbids trading on nonpublic information that was obtained or used “wrongfully.” That means that it was obtained by:

(A) theft, bribery, misrepresentation, or espionage (through electronic or other means)

(B) a violation of any Federal law protecting computer data or the intellectual property or privacy of computer users; or

(C) conversion, misappropriation, or other unauthorized and deceptive taking of such information, or a breach of any fiduciary duty or any other personal or other relationship of trust and confidence.

So that strikes me as a reasonable effort to reverse Newman without doing too much collateral damage. Under the Himes bill, unlike under current law, if you trade on information that you got from someone who breached a duty of confidentiality to give it to you, you are committing a crime even if that person didn’t get any personal benefit from giving it to you.6 But otherwise this list of things — theft, hacking, breach of “relationship of trust and confidence” – seems pretty close to the list of things that will get you in trouble now, so courts could just import existing insider-trading law without too much difficulty. (I will say that “espionage” is a weird one, though. Does that include just, like, snooping? I think snooping is legal now, depending on the exact form of the snooping.7)

In that sense, the Himes bill seems like the best of the ban-insider-trading bills so far. It does the least violence to existing law: The Reed-Menendez bill is a total reworking of the law to ban research, while the Lynch bill seems like an effort to keep current law (except Newman) but by rewriting it in different words, always a perilous undertaking. The Himes bill, unlike the Lynch one, tries to avoid redefining thorny concepts like “materiality” or “inside information” that have already gotten a workout in the courts. It just keeps as much of current law as possible consistent with throwing out the controversialNewman conclusion.9

Remember that it takes some effort to do that — the Himes bill is five pages long — only because there’s currently no law against insider trading,10 so even if you don’t want to start from scratch in forbidding it you sort of have to. Insider trading is criminalized by the courts under the very general prohibition in the Securities Exchange Act on using “any manipulative or deceptive device or contrivance” in trading securities.

From those unpromising beginnings, the courts have created a gigantic body of law based on the notion that it is “manipulative or deceptive” to use someone else’s information for your personal trading profits. But you could understand how a layman might read the “manipulative or deceptive” language in other ways. Since it doesn’t mean anything, you can read it to ban anything you think is unfair.11 And people seem to think that trading on information that everyone else doesn’t have is unfair.

Which leaves insider trading law in constant risk of surprising people: The law doesn’t match people’s intuitions, and it isn’t written down anywhere, so people keep thinking that it’s different from what it is. Writing it down in the form of the Himes bill might not make it match people’s intuitions. But at least it would make the law less surprising, which is worth something.

  1. Not legal advice! Nor was “just index” investing advice. 

  2. Consider pages 17-27 of the government’s Newman brief, which are almost entirely circumstantial. E.g.: 

    The pattern and timing of Newman’s trades confirmed that Newman understood he had access to material, nonpublic information. Knowing that the information about Dell’s earnings came from corporate insiders and was inconsistent with market expectations, Newman made large investments in Dell securities based on the inside information. Before Newman received the Dell tips in 2008, he rarely, if ever, held a position in Dell securities at the time of its quarterly earnings announcements. Throughout 2008, however, as Goyal provided accurate information in advance of Dell’s quarterly announcements, Newman made increasingly large investments in Dell securities.

    That’s not proof that Newman knew his Dell source was breaching a fiduciary duty. That’s proof that Newman thought the information was good. 

  3. Sic, and I wrote about the weird implications of that phrase, which seems to harbor a subtle technical error beyond its plural/singular problems. 

  4. Which I learned of from Integrity Research. 

  5. We descend into metaphysics. Since the Reed-Menendez bill is not yet law, it doesn’t make anything illegal. If it never becomes law, it never will. If it is impossible for it to become law, then it does not go “as far as possible to make it illegal to trade while in possession of ‘material, nonpublic information.’” It goes further than possible. Perhaps the Himes bill does go as far as possible, insofar as it is possible for the Himes bill to be enacted but not any stricter bill. Possibly. I’m going to tiptoe quietly away from this footnote. 

  6. Or if he did, and you didn’t know about it:

    It shall not be necessary that the person trading while in possession of such information (as proscribed by subsection (a)), or making the communication (as proscribed by subsection (b)), know the specific means by which the information was obtained or communicated, or whether any personal benefit was paid or promised by or to any person in the chain of communication, so long as the person trading while in possession of such information or making the communication, as the case may be, was aware, or recklessly disregarded that such information was wrongfully obtained or communicated. 
  7. E.g. having helicopters with cameras and tracking corporate jets both seem totally legal to me. But are they “espionage”? 

  8. Technically “inside information” isn’t even a thing in current law, though it has a colloquial use. But the Lynch bill gets pretty into defining it. Himes just uses “material” and trusts the courts to know what it means. 

  9. For myself, I think that the Newman conclusion is right: The goal of insider trading law is to punish people who misuse their insider status for gain at the expense of the shareholders they serve. If you just give out inside information out of the goodness of your heart, you are not stealing information for profit, and no crime has occurred. (And if someone else uses that information for gain, then he’s got no duty to the shareholders, and so again no crime has occurred.) But I realize that I’m in the minority on this one.

    I’m on firmer ground in saying that the Newman conclusion was obviously right as a matter of law; it pretty much just repeats the words of well-settled Supreme Court precedents. It’s just that no one thought those precedents meant what they said.  

  10. Except 14e-3 insider trading! A whole ‘nother kettle of fish. 

  11. Here’s Craig Pirrong on the Clayton Rule of Manipulation, which is that the concept of manipulation “is so broad as to include any operation of the cotton market that does not suit the gentleman who is speaking at the moment.” Or whatever market. 

To contact the author on this story:
Matt Levine at [email protected]

To contact the editor on this story:
Zara Kessler at [email protected]


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