Why is insider trading illegal? I think there are two main reasons:
- It is unfair: You shouldn’t trade if you have information that everybody else doesn’t have.
- 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 Connecticut4. Peter 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.5 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)