Fairness, Efficiency and Insider Trading: Deconstructing the Coin of the Realm in the Information Age

Whether and how the federal securities laws should restrict insider trading is one of the most hotly debated topics in the securities law literature. Paradoxically, both the theoretical analysis and the legal rules concerning insider trading remain extraordinarily vague and ill-formed. What is the special character of insider trading that leads to this apparently irresolvable puzzle? In this Article, I argue that there is, in fact, nothing special about insider trading that creates this dilemma, but rather there is something special about the nature of information itself. Accordingly, this theoretical dilemma is not limited to insider trading regulation, but rather pervades all areas of intellectual property law. In this Article, I situate insider trading regulation within the larger body of intellectual property law by discussing three potential allocations of the property right in valuable inside information. First, inside information could be treated as a public resource, meaning that a person in possession of inside information could not legally exploit that advantage for personal profit. Such a regime would forbid some or all insider trading by forcing the disclosure to the marketplace of inside information prior to trading. I argue that regulators should reject this alternative because, despite it\u27s proponents\u27 tendency to justify the rule in terms of fairness, this proposal is unlikely to foster fairness in any meaningful way. Alternatively, the property right in valuable inside information could belong to issuers, as the producers of such information. I argue that regulators should reject this alternative because, despite its proponents? tendency to frame their arguments in terms of promoting informational efficiency, a legal regime treating inside information as the property of the issuer is unlikely to further that goal. In fact, such proposals assume an affirmative answer to a question that is fiercely debated in other areas of intellectual property law: does creating a property right in information producers incentivize additional production to the extent necessary to offset the social costs of excluding others from use of the information? Finally, the property right in valuable inside information could reside with outsider traders (traders who possess inside information, but are neither insiders nor constructive insiders of the issuer). I argue that regulators should pursue this alternative because, although there is no need to encourage issuers to create valuable inside information, the need to encourage the dissemination of such information to the marketplace has been recognized for many years. Accordingly, I propose in this Article a system of federal securities regulation that would permit trading by corporate outsiders who did not receive their information in a tip from an insider or constructive insider. Such a system, I argue, provides the hope of filling in the gaps left by the current disclose or abstain system, by encouraging the reflection of material information in stock market price without disclosure of the actual inside information. At the same time, this proposal avoids the perverse incentives and negative impacts on market efficiency attendant in a system that permits insider trading by corporate employees

Fairness, Efficiency and Insider Trading: Deconstructing the Coin of the Realm in the Information Age

Whether and how the federal securities laws should restrict insider trading is one of the most hotly debated topics in the securities law literature. Paradoxically, both the theoretical analysis and the legal rules concerning insider trading remain extraordinarily vague and ill-formed. What is the special character of insider trading that leads to this apparently irresolvable puzzle? In this Article, I argue that there is, in fact, nothing special about insider trading that creates this dilemma, but rather there is something special about the nature of information itself. Accordingly, this theoretical dilemma is not limited to insider trading regulation, but rather pervades all areas of intellectual property law. In this Article, I situate insider trading regulation within the larger body of intellectual property law by discussing three potential allocations of the property right in valuable inside information. First, inside information could be treated as a public resource, meaning that a person in possession of inside information could not legally exploit that advantage for personal profit. Such a regime would forbid some or all insider trading by forcing the disclosure to the marketplace of inside information prior to trading. I argue that regulators should reject this alternative because, despite it\u27s proponents\u27 tendency to justify the rule in terms of fairness, this proposal is unlikely to foster fairness in any meaningful way. Alternatively, the property right in valuable inside information could belong to issuers, as the producers of such information. I argue that regulators should reject this alternative because, despite its proponents? tendency to frame their arguments in terms of promoting informational efficiency, a legal regime treating inside information as the property of the issuer is unlikely to further that goal. In fact, such proposals assume an affirmative answer to a question that is fiercely debated in other areas of intellectual property law: does creating a property right in information producers incentivize additional production to the extent necessary to offset the social costs of excluding others from use of the information? Finally, the property right in valuable inside information could reside with outsider traders (traders who possess inside information, but are neither insiders nor constructive insiders of the issuer). I argue that regulators should pursue this alternative because, although there is no need to encourage issuers to create valuable inside information, the need to encourage the dissemination of such information to the marketplace has been recognized for many years. Accordingly, I propose in this Article a system of federal securities regulation that would permit trading by corporate outsiders who did not receive their information in a tip from an insider or constructive insider. Such a system, I argue, provides the hope of filling in the gaps left by the current disclose or abstain system, by encouraging the reflection of material information in stock market price without disclosure of the actual inside information. At the same time, this proposal avoids the perverse incentives and negative impacts on market efficiency attendant in a system that permits insider trading by corporate employees

United States v. O\u27Hagan: Agency Law and Justice Powell\u27s Legacy for the Law of Insider Trading

The law of insider trading is judicially created; no statutory provision explicitly prohibits trading on the basis of material, non-public information. The Supreme Court\u27s insider trading jurisprudence was forged, in large part, by Justice Lewis F. Powell, Jr. His opinions for the Court in United States v. Chiarella and SEC v. Dirks were, until recently, the Supreme Court\u27s only pronouncements on the law of insider trading. Those decisions established the elements of the classical theory of insider trading under § 10(b) of the Securities Exchange Act of 1934 (the Exchange Act ). Under this theory, corporate insiders and their tippees who trade in their corporation\u27s securities while in possession of confidential information violate duties owed to the corporation\u27s shareholders with whom they trade. The Supreme Court\u27s recent decision in United States v. O\u27Hagan, which upheld the misappropriation theory of insider trading, provides an occasion for reassessing Justice Powell\u27s contributions to the law of insider trading. The misappropriation theory differs from the classical theory in that it applies when an agent or other fiduciary misuses information entrusted to her by her principal to trade in securities, whether or not those securities were issued by her principal. The Court\u27s decision in O\u27Hagan breaks new ground in establishing a foundation for insider trading based on common law agency principles, thereby departing from Powell\u27s vision of the scope of insider trading prohibited by § 10(b). This Article explores Justice Powell\u27s legacy for the law of insider trading and traces the development of insider trading jurisprudence through O\u27Hagan

Daily Eastern News: October 23, 2008

https://thekeep.eiu.edu/den_2008_oct/1021/thumbnail.jp

Reframing the Misappropriation Theory of Insider Trading Liability: A Post-O\u27Hagan Suggestion

For almost two decades, the United States Supreme Court was silent as to the validity of the so-called \u27fraud on the source misappropriation theory of insider trading liability. This changed in June 1997 when the theory received a resounding endorsement from the Court in United States v. O\u27Hagan. Critics of O\u27Hagan have argued that the Court\u27s decision reaches too far. However, this Article contends that the Court actually endorsed a theory that does not reach far enough. By analyzing and critiquing the reasoning of the majority opinion in O\u27Hagan, this Article demonstrates that the Court\u27s unnecessarily restrictive misappropriation theory will frustrate the prosecution of future cases involving trading on misappropriated information and may generate public mistrust of the SEC. This Article suggests a broader \u27fraud on investors version of the misappropriation theory, contending that investors in the marketplace are also deceived and defrauded when a person purchases or sells securities based on material, nonpublic information that has been misappropriated from the information\u27s source

Insider Trading in Derivatives Markets

The prohibition against insider trading is becoming increasingly anachronistic in markets where derivatives like credit default swaps (CDS) operate. Lenders use these instruments to trade the credit risk of the loans they extend. By design, CDS appear to subvert insider trading laws, insofar as lenders rely on what looks like insider information to transfer or externalize the risk of a loan to another institution. At the same time, the harm caused by using insider information in CDS markets can depart radically from the harms envisioned under existing case law. In the traditional account of insider trading, shareholders systematically lose against informed insiders. However, with CDS trading, shareholders of the debtor company can emerge as winners where this company enjoys access to cheaper credit and lower funding costs. A thorough re-thinking of traditional theory is thus required, as well as a more robust, theoretical account of the efficiency and welfare implications of insider trading in a world animated by complex derivatives markets. This Article shows that trading on insider information in CDS can improve at least the informational, if not also the allocative efficiency of financial markets in ways traditional accounts have scarcely anticipated. However, in doing so, CDS markets reveal that this informational gain can render markets too efficient where they impound new information selectively and with such force that market stability itself can suffer. Collectively, these observations suggest a need to revisit the insider trading prohibition itself – and to explore whether consistency can (and should) be brought to supervisory approaches in U.S. equity and derivatives markets