Jonathan Macey, a law professor at Yale University, has an op-ed in Tuesday’s WSJ arguing that the SEC’s definition of insider trading is too strict and at odds with Supreme Court precedent. (Hat tip Stacy Marie-Ishmael.)
Using the ongoing Galleon case as an example, Macey says there is an important distinction between Raj Rajaratnam allegedly bribing Rajiv Goel for tips on Clearwire and other allegations that “accuse Mr. Rajaratnam of simply talking to people and then trading”.
This failure to offer clear parameters on the definition of insider trading has a long and bitter history, Macey adds:
The prosecution of Mr. Rajaratnam is not an isolated fight but rather part of an ongoing doctrinal war pitting the rather extreme views of the Securities and Exchange Commission against the carefully considered law of insider trading articulated by the Supreme Court. The SEC does not draw a distinction between trading on the basis of legitimate albeit unorthodox research and illegal trading on the basis of improperly acquired proprietary information. But it should.
In contrast, the Supreme Court has offered a narrower and, in Macey’s opinion, superior definition:
The Supreme Court recognizes that if a person acquires information in the course of legitimate business activities, like research or mining sources appropriately, then he has a right to that information and should be able to trade without disclosing it. The government, on the other hand, espouses a socialist philosophy that valuable information belongs to the people—regardless of how it was obtained.
This is going too far: although the SEC can appear over-zealous to some in its pursuit of insider trading, it hardly considers all market information to be a public good. (We’re also frequently amazed at the amount of farce within SEC complaints, suggesting the bar is pretty high for successful investigations.) Here is its pithy definition of insider trading:
“Illegal insider trading is the act of trading, or causing someone to trade, on the basis of material non-public information in violation of a duty.”
Macey’s op-ed mostly addresses the “non-public” aspect of this definition, arguing that forensic research — including going through companies’ garbage — is both legal and good. This line of thinking goes back to at least Henry Manne, author of Insider Trading and the Stock Market (1966).
In essence, according to James Surowiecki (2005), Manne and his disciples claim insider information is at best positive and at worst harmless; it lubricates the market, providing incentives for trading — and since it is usually accurate, moves prices in the “right” direction.
There are two problems here, however, related to efficiency and fairness. It’s hard to see that opacity beats transparency for efficiency. As John Gapper points out, there are enough pre-release share spikes and dives to suggest that advance earnings tips are common. The Manne line would also encourage information hoarding and in turn, principal-agent problems.
Insider trading should certainly not be defined so that it deters tenacious research and analysis. (There’s little evidence that this is the case — quite the opposite, actually.) Even — and sometimes even especially — if the subjects of analysis oppose such research. In that sense, there’s a analogy here to journalism, where the law should aim to ensure accuracy and not seek to overly protect the subjects of research.
The difference, is that, put crudely, journalists strive to be the first to make material non-public information public, where as traders benefit from keeping non-public information non-public for as long as possible.
(Digression: Will this distinction erode as more bespoke news services develop?)
And it’s the nature of what is public or non-public information that gets to both the heart of Macey’s article and whether insider trading is fairly constructed. At one extreme, there is the “socialist” conception of information to which the SEC is beholden, according to Macey.
Any information not widely and easily accessible would thus be described as non-public. Any form of informational arbitrage based on being a harder working, or better connected, or a smarter analyst would be prohibited.
At the other extreme, there is the Manne thesis: the concepts of public and non-public information are basically irrelevant. There’s only useful and not useful information. Mosaic theory doesn’t matter — use Rothko theory for all we care.
As ever, the answer should lie somewhere in the middle. It’s neither fair nor efficient that institutional investors are able to trade on information that they and only they could access. However, non-public/public can’t be a static concept — it can’t rule out the obtaining of information through research, broadly defined. We’re not sure where that leaves the line. But it’s a start.
And what’s certainly clear is that the current lack of clarity benefits the SEC more than anyone else.
Related links:
The Feds must cast their net wisely – John Gapper
Galleon trial coverage – FT
A customizable client compliance programme – FT Alphaville
Capitol Gains – New Yorker (2005)
Insider Trading Lessons For Executives – Securities Law Blog