Insider Trading--Should it Be Fully Legal?

[Number Six]

I'm on a libertarian forum where many members believe that what is against the law should be legalized.

A couple comments: "There should be nothing illegal about insider trading. It cannot be defined even in any meaningful sense."

Also the moderator quoted this guy as making an argument for making it fully legal:


"The greatest legal scholar/free market economist of the 20th century argues against all laws against insider trading. He founded the law & economics programs at the University of Miami, Emory, and George Mason.

Manne: "Insider Trading and the Stock Market" (1966).

http://en.wikipedia.org/wiki/Henry_Manne

Here is a list of convictions from the SEC:

http://www.sec.gov/spotlight/insidertrading/cases.shtml

Is the government wrong to convict people of "insider trading?"

[Hyrion]

I would philosophically say no.

It would be far too easy for the BOD/Executives of any company to manipulate news events in order to personally profit from causing others to panick or buy into the shares on false promises.

Of course, there's nothing stopping the more corrupt from doing that today but at least they have to try and keep it quiet from the authorities.

If a person has to con someone in order to profit perhaps the person should rethink what they're trying to sell and find some honest work.

An open market does not mean it should also be corrupt.

[Judge Roy Bean]

Insider trading is much like prostitution. Everyone knows it's going on but there's no effective way to stamp it out completely.

[Arthur Rubin]

I have mixed feelings about this. Insider trading can do harm, but the laws must either forbid trading on knowledge of a specific fact known to be relevant insider information, or it would prohibit trading by anyone who has nonpublic information related to a publicly traded company. Although I haven't read the recent court decision throwing out an insider-trading conviction, it appears that the judge agrees that the law must require the first, even though it's not written that way.

[Famspear]

There should be nothing illegal about insider trading. It cannot be defined even in any meaningful sense.

People should not study art or engage in debates about whether a particular work is art. The term "art" cannot be defined in any meaningful sense.

Because people disobey vehicle traffic laws and most violators are never detected, we should repeal all traffic laws. Every man for himself! Freedom!

Repeal the anti-trust laws, as well! Let the "free market" decide! In the absence of regulation, the free market will decide in favor of monopoly, just as it did in the late 1800s before these anti-trust laws were passed! Rockefeller was right! Monopoly is the way to go!

[JamesVincent]

The problem with insider trading, at least to me, is in defining it. What information do we consider privileged? I remember reading a case, a long time ago, about someone who was prosecuted it after being given a tip from another person. The person received the tip but also looked for public signs that the company in question was on the rise. He found them, invested heavily, and made a nice profit. He was later charged for insider trading, along with the person who gave them the tip. The case was dismissed later but he still had to set up a defense before that happened.

One thing they look for, as I understand it, is whether the information used is non-public or privileged in any way. Ok, what if you're in the military or a military contractor and you hear that a certain company is going to be awarded a contract and, more then likely, they will be seeing large growth because of it. You have no ties to the company and neither does the person telling you, just heard it through the grapevine. You invest heavily and make money. Are you guilty of insider trading since the contract hasn't been announced yet and/ or is classified and not public information?

Unless you can actually fully define what circumstances trigger the charge then the law cannot be really enforced in any substantial way. And it would seem that the law defining insider trading falls in that category.

[Arthur Rubin]

There seems to be disagreement here as to what insider trading is:

1. Releasing or making use of "insider" information for gain.
2. Manipulating news releases so as to affect the value of stock you own (no trading involved).
3. Releasing false "insider" information so that people making use of it (in violation of #1) get screwed.

I was talking about #1, and famspear seems to be talking about #2

[Number Six]

That SA Cohen was not directly caught in insider trading whereas his employees were indicates how hard it is to catch these white collar law breakers ("In November 2012, he began to be implicated in a large criminal insider trading scandal. In July 2013, SAC was charged by the Securities and Exchange Commission with failing to prevent insider trading." http://en.wikipedia.org/wiki/Steven_A._Cohen) Those who challenge the value of basic laws of civilization show the nature of the perversity. It strikes me that they want an unregulated society either because they have or would derive immense benefit as alphas driven by instincts and not by right reason. The fact that they look to economic gurus like Manne, and not groups or schools of economics shows that they have yet to receive proper opposition to their theoretical ideas which are unlikely to ever be practical bases on causal consequences.

[Famspear]

There seems to be disagreement here as to what insider trading is:

1. Releasing or making use of "insider" information for gain.
2. Manipulating news releases so as to affect the value of stock you own (no trading involved).
3. Releasing false "insider" information so that people making use of it (in violation of #1) get screwed.

I was talking about #1, and famspear seems to be talking about #2

No, that's not what I'm saying, and I don't follow your train of thought here. I wasn't trying to define insider trading. I was making an attempt -- apparently ineffectually -- to poke fun at people who say that something should not be illegal and who use, as support for that proposition, the idea that the "thing" being made illegal cannot be defined "in any meaningful sense."

I don't study federal securities law on a frequent basis, but my reading of the Newman case (which deals only with "tippee" liability, not the liability of the "insider" who gives the information to the "tippee") is as follows. The government must prove each of the following, beyond a reasonable doubt:

(1) that the corporate insider was entrusted with a fiduciary duty; and

(2) that the corporate insider breached his fiduciary duty by (a) disclosing confidential information to a tippee, (b) in exchange for a personal benefit; and

(3) that the tippee knew of the insider's breach, that is, the tippee knew the information was confidential, and also knew that the insider divulged it for personal benefit; and

(4) that the tippee still used that information to trade in a security, or to tip yet another individual for personal benefit.

I believe the Court of Appeals is saying that the tippee's liability is derivative -- the tippee has liability (if at all) only if the insider has liability. And the insider can have liability only if the insider has breached a duty.

The insider's duty consists of TWO parts, not one. The insider's mere release of confidential information is not enough. The insider must have also intended to obtain a personal benefit. If the INSIDER did not release the information for personal benefit, then the insider cannot be held liable.

And if the insider cannot be held liable, then the tippee cannot be held liable. The tippee cannot be punished under the federal securities law for using information where the release of that information to the tippee by the insider did not expose the insider to legal liability under the federal securities law.

The "new" wrinkle in the Newman case: the Court of Appeals has now made clear that for the tippee to be liable, not only must the insider have done the deed for personal benefit, but the tippee must be AWARE that the insider did the deed for personal benefit.

Anyway, that's my quick and dirty analysis.

[Famspear]

According to the Court of Appeals, the following was the erroneous instruction that the district court gave to the jury. The district court told the jury that the Government had to prove:

(1) that the insiders had a "fiduciary or other relationship of trust and confidence" with their corporations;

(2) that they "breached that duty of trust and confidence by disclosing material, nonpublic information";

(3) that they "personally benefited in some way" from the disclosure;

(4) "that the defendant . . . knew the information he obtained had been disclosed in breach of a duty"; and

(5) that the defendant used the information to purchase a security.

The Court of Appeals stated:

Under these instructions, a reasonable juror might have concluded that a defendant could be criminally liable for insider trading merely if such defendant knew that an insider had divulged information that was required to be kept confidential. But a breach of the duty of confidentiality is not fraudulent unless the tipper acts for personal benefit, that is to say, there is no breach unless the tipper "is in effect selling the information to its recipient for cash, reciprocal information, or other things of value for himself. . . ." Dirks, 463 U.S. at 664 (quotation omitted). Thus, the district court was required to instruct the jury that the Government had to prove beyond a reasonable doubt that Newman and Chiasson knew that the tippers received a personal benefit for their disclosure.

(italics added by Famspear).

In other words, by separating the description of the insider's duty (which is a two part duty) into separate elements -- numbered 2 and 3 above -- and by failing to point out that the "knowledge" requirement in element 4 applied not only to element 2 but also to element 3, the district court misled the jury as to the "breach" of which the defendant was supposed to be aware in order to be guilty. The way the instruction was presented to the jury, element 3 (the "personal benefit" element) -- which is really part of the "breach" -- appears to be something that the defendant could be unaware of and yet still be found guilty. The Court of Appeals ruled that this was erroneous.

[Famspear]

The Court of Appeals decision is even better understood by looking back at the leading U.S. Supreme Court decision in the case of Dirks v. Securities and Exchange Commission, 463 U.S. 646 (1983). In that case, the "tippee" received confidential information from an insider, a former employee of a company. But, the reason the insider disclosed the information to the tippee, and the reason the tippee disclosed the information to third parties, was to blow the whistle on massive fraud that was going on at the company. As a result of the tippee's efforts the fraud was uncovered, and the company went into bankruptcy. But, while the tippee had given the "inside" information to clients who made profits from the information, the Supreme Court ruled that the tippee could not be held liable under the federal securities laws for the simple reason that the insider from whom he received the information was not releasing the information for an improper purpose (personal benefit), but rather for the purpose of exposing the fraud. The Supreme Court ruled that the tippee could not have been aiding and abetting a securities law violation committed by the insider -- for the simple reason that no securities law violation had been committed by the insider.

Stated another way:
Merely releasing confidential information might well be a breach of a legal duty owed by the insider to the company, but such a release is not, by itself, federal securities fraud. To have federal securities fraud, the insider must also have an improper purpose (e.g., intent to obtain personal gain).

And the tippee's knowledge of only half of the insider's breach that would constitute federal securities fraud is not enough for the tippee to be guilty of federal securities fraud -- which is what the insider trading law is about.

[Famspear]

The Court of Appeals for the Second Circuit in Newman also had this to say:

Although this Court has been accused of being "somewhat Delphic" in our discussion of what is required to demonstrate tippee liability, United States v. Whitman, 904 F. Supp. 2d 363, 371 n.6 (S.D.N.Y. 2012), the Supreme Court was quite clear in Dirks. First, the tippee's liability derives only from the tipper's breach of a fiduciary duty, not from trading on material, non-public information. See Chiarella, 445 U.S. at 233 (noting that there is no "general duty between all participants in market transactions to forgo actions based on material, nonpublic information"). Second, the corporate insider has committed no breach of fiduciary duty unless he receives a personal benefit in exchange for the disclosure. Third, even in the presence of a tipper's breach, a tippee is liable only if he knows or should have known of the breach.

While we have not yet been presented with the question of whether the tippee's knowledge of a tipper's breach requires knowledge of the tipper's personal benefit, the answer follows naturally from Dirks. Dirks counsels us that the exchange of confidential information for personal benefit is not separate from an insiders fiduciary breach; it is the fiduciary breach that triggers liability for securities fraud under Rule 10b-5. For purposes of insider trading liability, the insider's disclosure of confidential information, standing alone, is not a breach. Thus, without establishing that the tippee knows of the personal benefit received by the insider in exchange for the disclosure, the Government cannot meet its burden of showing that the tippee knew of a breach.

(italics in the original).

The Court then takes a swipe at what the Court apparently views as the Justice Department's over-reach in prosecuting certain tippees:

The Government's overreliance on our prior dicta merely highlights the doctrinal novelty of its recent insider trading prosecutions, which are increasingly targeted at remote tippees many levels removed from corporate insiders. By contrast, our prior cases generally involved tippees who directly participated in the tipper's breach (and therefore had knowledge of the tipper's disclosure for personal benefit) or tippees who were explicitly apprised of the tipper's gain by an intermediary tippee. See, e.g., Jiau, 734 F.3d at 150 ("To provide an incentive, Jiau promised the tippers insider information for their own private trading."); United States v. Falcone, 257 F.3d 226, 235 (2d Cir. 2001) (affirming conviction of remote tipper where intermediary tippee paid the inside tipper and had told remote tippee "the details of the scheme"); Warde, 151 F.3d at 49 (tipper and tippee engaged in parallel trading of the inside information and "discussed not only the inside information, but also the best way to profit from it"); United States v. Mylett, 97 F.3d 663 (2d Cir. 1996) (tippee acquired inside information directly from his insider friend). We note that the Government has not cited, nor have we found, a single case in which tippees as remote as [Todd] Newman and [Anthony] Chiasson [the defendants in this Newman case] have been held criminally liable for insider trading.

(italics in original; large font added).

[Number Six]

All you have to do is do a basic search on a site like "Zero Hedge" involving "insider trading" that will bring up matches like this one: http://www.zerohedge.com/news/2012-11-2 ... it-history And one of the guys behind the site, Daniel Ivandjiiski, was banned from the industry for insider trading himself. It takes one to know one probably.

Cohen now wants to hire some prosecutors and FBI agents to come work for him: http://dealbook.nytimes.com/2014/12/15/ ... iness&_r=0

[noblepa]

I used to work for Ernst & Whinney, then one of the so-called "Big Eight" accounting firms. E & Y has since merged with Arthur Young to form Ernst & Young. I was not an accountant or auditor, but, as "professional staff" (IT), I was subject to the firm's rules about such things.

At a meeting, one of the partners in charge of compliance gave the following example. If I, as an auditor, was working on the annual audit for XYZ Corp., and I came home and told my wife that we were going to give a negative audit letter, and my wife told her next-door neighbor the next day over coffee, who in turn told her husband, who then called his broker and sold all his stock (or worse, shorted it) in XYZ Corp., we were ALL guilty of insider trading. This despite the fact that only one of us had any financial gain.

Now, IANAL, and this opinion was told to me 30 years ago. Laws may have changed. Court decisions may have changed the way insider trading is prosecuted. So take this with a grain of salt.

[Famspear]

I used to work for Ernst & Whinney, then one of the so-called "Big Eight" accounting firms. E & Y has since merged with Arthur Young to form Ernst & Young. I was not an accountant or auditor, but, as "professional staff" (IT), I was subject to the firm's rules about such things.

At a meeting, one of the partners in charge of compliance gave the following example. If I, as an auditor, was working on the annual audit for XYZ Corp., and I came home and told my wife that we were going to give a negative audit letter, and my wife told her next-door neighbor the next day over coffee, who in turn told her husband, who then called his broker and sold all his stock (or worse, shorted it) in XYZ Corp., we were ALL guilty of insider trading. This despite the fact that only one of us had any financial gain.

Now, IANAL, and this opinion was told to me 30 years ago. Laws may have changed. Court decisions may have changed the way insider trading is prosecuted. So take this with a grain of salt.

With all due respect to the partner in charge of compliance at Ernst & Whinney (and this is not an areas of expertise for me, so take this with a grain of salt), I believe he might have been mistaken -- even under the law thirty years ago -- on the facts as you've related them.

Forget about the knowledge of personal gain component for a second. Even thirty years ago, I believe there had to be more than just a leak of confidential information. The leak also had to be for an improper purpose -- generally, personal gain, which could be financial gain or enhancement of business reputation of the insider (in this case, the auditor).

The Supreme Court's decision in Dirks was 31 years ago and, clearly, under Dirks, the only persons who arguably intended to personally benefit on the hypothetical you gave (at least as I understand it) were the last two people in the chain: the next-door neighbor and the neighbor's spouse.

The auditor -- the person who owed the duty to keep the information confidential -- was a foolish blabbermouth. But, if he did not leak the information to his wife for purpose of personal gain (and that's "IF"), then he might not have been liable, even 30 years ago.

The neighbors owed no duty to the corporation, at least under the facts as I understand them.

Regarding the neighbor who actually benefitted, I would look to what the Supreme Court stated in Dirks:

We were explicit in Chiarella in saying that there can be no duty to disclose where the person who has traded on inside information "was not [the corporation's] agent, . . . was not a fiduciary, [or] was not a person in whom the sellers [of the securities] had placed their trust and confidence." [ . . ] Not to require such a fiduciary relationship, we recognized, would "depar[t] radically from the established doctrine that duty arises from a specific relationship between two parties" and would amount to "recognizing a general duty between all participants in market transactions to forgo actions based on material, nonpublic information."

--from Dirks v. Securities and Exchange Commission, 463 U.S. 646, at 654-655 (1983) (bracketed material and quotation marks in the original).

The Court went on to say that the mere possession of non-public information does not preclude the holder of that information from trading, even if the information originally came from an insider:

The SEC's position, as stated in its opinion in this case, is that a tippee "inherits" the Cady, Roberts obligation to shareholders whenever he receives inside information from an insider [. . . ] This view differs little from the view that we rejected as inconsistent with congressional intent in Chiarella. [ . . . ] In effect, the SEC's theory of tippee liability in both cases appears rooted in the idea that the antifraud provisions require equal information among all traders. This conflicts with the principle set forth in Chiarella that only some persons, under some circumstances, will be barred from trading while in possession of material nonpublic information. [ . . ] Imposing a duty to disclose or abstain solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts [ . . . ]

However, the Court also stated:

The conclusion that recipients of inside information do not invariably acquire a duty to disclose or abstain does not mean that such tippees always are free to trade on the information. The need for a ban on some tippee trading is clear. Not only are insiders forbidden by their fiduciary relationship from personally using undisclosed corporate information to their advantage, but they also may not give such information to an outsider for the same improper purpose of exploiting the information for their personal gain. [ . . . ] Thus, some tippees must assume an insider's duty to the shareholders not because they receive inside information, but rather because it has been made available to them improperly. Determining whether an insider personally benefits from a particular disclosure, a question of fact, will not always be easy for courts. But it is essential, we think, to have a guiding principle for those whose daily activities must be limited and instructed by the SEC's inside-trading rules, and we believe that there must be a breach of the insider's fiduciary duty before the tippee inherits the duty to disclose or abstain.

But, under this language, the insider still has to have an "improper purpose" such as trying to use the information for his "personal advantage." Did he have an improper purpose when he blabbed to his wife at the supper table? I'm not sure. We could interpret the facts differently. If the auditor gave his wife the confidential information to enhance his "reputation" with her, would that be enough of a personal gain to be considered an improper purpose?

If so, then the next questions could be: Would the courts back in 1983 have viewed the law the way the Second Circuit viewed it a few days ago in the Newman case? Would the courts back then have said: "Not only does the insider (the auditor) have to have intended to personally benefit, but the three tippees (the auditor's wife, the neighbor, and the neighbor's spouse) ALSO have been AWARE of the auditor's intent to personally benefit?

I don't know the answer to those questions.

[KickahaOta]

I would think about it this way, Famspear: If you're in charge of compliance, and you're describing to traders what they shouldn't do, and your ass will be in a sling if someone commits insider trading, you have a vested interest in being overinclusive rather than underinclusive in your warning.

[Famspear]

I would think about it this way, Famspear: If you're in charge of compliance, and you're describing to traders what they shouldn't do, and your ass will be in a sling if someone commits insider trading, you have a vested interest in being overinclusive rather than underinclusive in your warning.

Well, I don't know whether you're a CPA, but I am, and I don't think of it that way.

In my view, there's really no compelling reason for a compliance person at a big 8 firm (now big 4 firm) to do that. First of all, even if there were no federal securities laws, it is a criminal offense in at least some states (Texas, for example) for a Certified Public Accountant or even any employee (even a secretary) of a CPA to voluntarily disclose information communicated to the CPA, or to a partner, member, shareholder, or employee of the CPA, by a client in connection with services provided to the client by the CPA firm, except with the permission of the client. (There are several statutory exceptions to that rule -- such as in the case of a court order or an IRS summons.) This rule applies to information from ANY client, not just a publicly-traded company. The rule applies to any kind of service, whether it be audit, tax, consulting, whatever.

Further, the CPA could have his license pulled by the state board, even if he is not prosecuted.

I worked for Arthur Young & Company (before the merger with Ernst) and, curiously, I actually don't recall ever getting a formal presentation from anyone on the federal securities law requirements. The federal rules may well have been in the AY employee manual, which was an extensive book (and all professional staff had a copy, which was in loose-leaf format and updated regularly).

In the case of federal tax work, you also have the criminal provisions of Internal Revenue Code 7216 that apply to anyone who is in the business of preparing federal income tax returns.

But, client confidentiality is so ingrained in many CPAs anyway -- long before they're licensed. At least when I was in college, we learned the code of ethics of the American Institute of CPAs, which forms much of the basis for the official ethics rules incorporated into state statutes and regulations for CPAs.

EDIT: PS: Revealing confidential client information to one's spouse is a bad idea, not because the spouse cannot be trusted to keep it a secret (assuming that to be the case), but because it's against the law. There is no exception in the law in Texas, at least, that allows a CPA to pass along client information to the CPA's spouse. Period.

[fortinbras]

Insider trading, of which there are plenty of examples over the years, is no unlike playing poker with marked cards. Those with the inside information deceive and rob the general public of investors, essentially turning what should be regulated investments into a swindle.

[Jeffrey]

The poker analogy is very good because the gains from insider trading don't appear out of nowhere, they come from other traders.

[Number Six]

The "Flash Boys" book by Michael Lewis was about a similar form of fraud--unfair advantages by insiders who were getting their cut before they even executed the trades for their customers.

http://en.wikipedia.org/wiki/Flash_Boys