Some Zuccotti Park Thoughts On Insider Trading

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It’s fun to get all riled up about insider trading! So let’s.

But first, I see you have some XYZ shares. Would you like to sell them to me? Here are some things you might want to know about it:
1.Warren Buffett is secretly buying loads of it.
2.Congress is going to do something that will make it go up, like kill pending legislation that would restrict its profits.
Let's say I know those things and you don't. I buy XYZ from you. Have I committed a crime? Maybe - but it's not as easy as that.

Let’s start with what insider trading is. Actually let's start with what it isn't. Henry Blodget gives a popular simplification, “The definition of insider trading is trading while in possession of material non-public information.” If you think that, then clearly Congresspeople are committing crimes by trading on the knowledge that they’re going to earmark loads of cash to a company or deregulate it or just blow up the financial system or whatever they’re up to.

But that’s not the definition of insider trading, or at least of illegal insider trading. You can tell that by doing this little thought experiment:

1. Buffett knows he's going to buy ten yards or so of IBM
2. He knows that that will move the market, so it's material
3. He hasn't told anyone yet, so it's non-public
4. So he's got "material" "non-public" information about IBM
5. He buys it anyway
6. Has he committed a crime?

Duh, no. Obviously buying while knowing that you're buying can't really be illegal, even if you're Warren Buffett.* Just trading while you have material nonpublic information isn't enough for it to be criminal. Instead, you need to be "in breach of a fiduciary duty or other relationship of trust and confidence" for it to count. Warren Buffett is okay trading while he knows about his own intentions because that's, like, why he has those intentions. David Sokol, perhaps not so much. In fact, the SEC is so solicitous of Buffett keeping his secret sauce secret and saucy that it lets him avoid otherwise applicable rules about disclosing stock holdings so that he can build his stake without pushing the stock up.

Similarly, it's not illegal for Congress to trade just because it has inside information: it has to have some sort of duty to or agreement with someone to keep that information secret. Now, maybe it does. Blodget cites a law professor who claims that Congress does have that duty, to the people who elected it, and that "nonpublic congressional information constitutes property which, like congressional funds and tangible property, rightfully belongs to the federal government and its citizens," which so depressingly and obviously should be right but which I suspect isn't. Other law professors are skeptical, and the fact that there was a proposed law (which went nowhere) to make Congressional insider trading illegal certainly suggests that - well, that Congress thinks it's currently legal, for whatever that's worth.

One thing to hold in your heart when you think about the U.S. securities laws is that, while they are in part designed to protect little investors and whatnot from big evil investors, they're really designed to protect big nice companies from big evil investors. Thus you could get a little riled up about the fact that Buffett gets special treatment in not disclosing his positions - but you could also reasonably ask why anyone should have to disclose their positions. The answer is that we have a disclosure regime that was put in place in the 1960s to protect companies from hostile takeovers. Because, y'know. Companies hire lots of lobbyists.

That regime is reflected in the current practice: the SEC likes Buffett and other money managers to tell everyone what they're up to, but lets company-friendly non-activist investors like Buffett skip that disclosure if "it would be likely to cause substantial harm to the Manager’s competitive position." No such luck for activists and raiders: if you buy over 5% of a company and are not a passive investor, you have to put up a 13D disclosing it, and the SEC doesn't give a damn about your competitive position. Sometimes that leads to weird workarounds, but they mostly don't work.

You can look at insider trading through the same lens. If you believe that insider trading law is intended to create a level playing field for all investors, you'd be confused by things like the apparent legality of Congressional insider trading, or the fact that knowing what Buffett is up to prevents Sokol, but not Buffett, from trading. If your model of insider trading prohibition is "the SEC doesn't want insiders to front-run companies on mergers and stuff, because that would make deals more expensive for those companies, and it wants corporate employees to have an incentive to fix problems rather than just shorting to profit from them," then those cases are easier. As is the story of Foster Winans, whom I've written about before. Winans wrote a column in the Wall Street Journal that moved the stocks he covered, and he and his buddies traded in advance of the column to make money front-running his picks. The Supreme Court affirmed his conviction for insider trading, but also said:

Admittedly, … the Wall Street Journal or its parent, Dow Jones Company, might perhaps lawfully disregard its own confidentiality policy by trading in the stock of companies to be discussed in forthcoming articles. … Although the employer may perhaps lawfully destroy its own reputation, its employees should be and are barred from destroying their employer’s reputation by misappropriating their employer’s informational property. … Here, appellants, constrained by the employer’s confidentiality policy, could not lawfully trade by fraudulently violating that policy, even if the Journal, the employer imposing the policy, might not be said to defraud itself should it make its own trades.

Got it? The Journal could creepily profit by trading in advance of its own column, but the guy who wrote the column couldn't.

Criminalizing insider trading is popular because it's easy to misrepresent what it's about. Prosecutors can posture that “Insider trading simply makes a mockery of the principle that no one individual has an advantage in the market ... It’s completely wrong that it’s a victimless crime,” and courts calculate sentences based on how much the "victims" "lost," but that's not really the principle that the laws protect.

Insider trading law isn't really about protecting the E*Trade baby from big scary Raj Rajaratnam; even without insider trading big accounts have access to expert networks, IPO allocations, better research, better technology, etc. etc. compared to small investors. It's about protecting Procter & Gamble from Raj: P&G doesn't want its board members leaking their discussions, and it doesn't want people dumping it stock in advance of an earnings miss. And the Procter & Gambles of the world are the ones who the securities laws were written for. If you remember that the securities laws are mainly intended to protect companies, not small investors, from big investors, then they will make more sense. And if you remember that one thing that Congress cares more about than big companies is itself, then you will not be surprised to see that Congressional insider trading remains legal.

No, It Is NOT "Legal" For Congress To Insider-Trade -- The SEC Should Launch Investigation Immediately [BI]

Congressional insider trading errors [Stephen Bainbridge]

One Secret Buffett Gets to Keep [DealBook]

Earlier: If We’re Not Supposed To Care About What S&P Says, Why Do We Care When They Said It?

* Though actually it kind of is for companies buying their own stock, which is why Berkshire did disclose in advance that it was buying back its own shares.

Related

After The STOCK Act It Will Still Be Legal To Trade On Congressional Inside Information*

Here's a sort of touching monologue from David Einhorn's call with Punch: If you’ve done the analysis, and come to the conclusion that on it’s own, the company is not going to make it, it makes all of the sense in the world to raise equity at whatever the price is, so that you can know that the company, you know, is – is going to make it. Now, what that brings to my mind though is, you know, obviously we haven’t done your analysis, we haven’t done -- signed an NDA; I don’t know that we’re going to sign an NDA, because we prefer to just remain investors, but from my perspective, and I’ll be just straight up with you, is that gives a lot of signalling value. And the signalling value that comes from figuring out the company has figured out that it’s not going to make it on it’s own is that we’ve just grossly misassessed the -- you know what’s going on here. And -- and that, that will cause us to have to just reconsider what we’re doing, which is not the end of the world to you. You will continue on even if we don’t continue on with you. You could sort of see why the FSA read that to mean that he was insider trading. Like ... (1) You have told me something with signalling value. Sorry - "a lot of signalling value." (2) I will now act on that signal. (3) Don't be mad. "Signalling value" sure sounds like it means "material nonpublic information," doesn't it? Now as we've discussed before, trading on that information would not be enough to make Einhorn guilty of insider trading in the US, though maybe it wouldn't be exactly a great idea here either. Why? Because in our weird but sort of sensible insider trading laws, it's just not illegal to trade on material nonpublic information. It's only illegal to trade based on material nonpublic information that was obtained in violation of some sort of duty of confidence. Since Einhorn didn't sign an NDA, he had no duty of confidence. And since the Punch CEO and bankers weren't tipping him for nefarious purposes, but were instead sounding him out on the company's behalf as a shareholder and potential investor in a new capital raise, they weren't breaching their duty of confidence. You could quibble with the details of that but it's basically the law here. In England not so much. That also seems to be the law for our friends in Congress, who recently passed a law making it illegal for them to insider trade, which is worrying some people who make their living from trading on Congressional inside information: