For Insider Trading, Mr. Bumble Was Right — “The Law Is a Ass”
In Oliver Twist, Mr. Bumble, whose wife was of a type that John Mortimer later immortalized as “she who must be obeyed,” was told that “the law supposes that your wife acts under your direction,” his response was apt:
“If the law supposes that … the law is a ass – a idiot.”
Charles Dickens, Oliver Twist.
I read with interest Henry Manne’s op-ed piece in the April 29, 2014 Wall Street Journal, Busting Insider Trading: As Pointless as Prohibition, a link to which can be found to the right. Dean Manne, a devoté of the application of economic principles in the law, discusses the pointlessness of our current insider trading legal regime. He focuses on the fecklessness of devoting major enforcement resources to this effort, but also notes towards the end that: “Insider trading not only does no harm, it can have significant social and economic benefits including a more accurate pricing of stocks.” How true, and how generally ignored, that is.
The law of insider trading is a mess. Even highly-experienced securities lawyers can disagree about whether particular trading scenarios are lawful or unlawful. The result is that uncertainty over what is permitted causes securities investors who want to comply with the law — and to avoid costly and potentially debilitating SEC investigations of trading activity — to refrain from participating in market transactions that, as part of overall market activity, would help make the securities markets more efficient, at least in the sense that security values truly reflect available information. Any securities lawyer who has advised clients in this area knows that what often is the critical consideration is not whether a trade is lawful or unlawful, but whether the SEC might become interested and commence an investigation, the costs of which would obliterate any possible profit.
In the next several posts, we will examine how this area of law became such a mess. It is a tale that shows how statutory law can stray far from the legislative enactment that creates it, and also shows the enormous power of unelected officials — chiefly administrative government employees and appointed judges — to mold the law in a form they choose, even if it becomes a gerry-built embarrassment.
Part I: The Securities Exchange Act of 1934 Signed Into Law Gets Revised by Administrative Fiat and a New Version Gets Embraced by the Courts
For years, the SEC’s insider trading enforcement program has been driven by the purported concept of equal access to information – that the securities markets must be (or be perceived to be) fair to all participants, and to accomplish that, we have to eliminate informational advantages available only to some market participants. Of course, that is not, and has never been, the law, nor should it be. (More on that below.) But it is the vision that has driven SEC policy-making and enforcement for fifty years.
Yet, this concept that the sine qua non of fair markets is that all participants must come to the marketplace as informational equals is facially inconsistent with the economic principles on which the financial markets are founded. If they could be forced to confront the issue head-on, even SEC decision-makers would have to agree with this, because they fully understand that an efficient securities market requires price-setting mechanisms that depend on the effect of incorporating unequal information sources into the buy and sell process. A “fair” market requires a mechanism that delivers a “fair” price for goods (or securities) being bought and sold. In the securities markets, it means that the relative prices among various securities available for investment should, to the extent possible, reflect the value of those securities to investors. (See Smolowe v. Delendo Corp., 136 F.2d 231, ___ (2d Cir. 1943) (The goal of the 1934 Act, as reflected in §2, “was to insure a fair and honest market, that is, one which would reflect an evaluation of securities in the light of all available and pertinent data”).)
Although “insider trading” (however that might be defined) is viewed by many as improper, it was accepted as a part of securities trading when the Securities Exchange Act of 1934 was enacted. The 1934 Act sought “to insure the maintenance of fair and honest markets” for securities transactions (Section 2), but Congress never thought that encompassed preventing “insider trading.” The only forms of “insider trading” targeted in the 1934 Act as improper were short-term trades by officers or directors (purchases and sales within a six-month period). What is now section 16(b) of the 1934 Act provided that profits from such purchases and sales (“short-swing profits”) had to be paid to the Company. This was true whether or not the trades were based on, or made in possession of, material nonpublic information about the Company. It was plainly understood at the time that the statute did not otherwise address insider trading, and certainly did not prohibit it. (See Hearings Before the House Committee on Interstate Banking and Foreign Commerce, H.R. 7852 & H.R. 8720, 73rd Cong., 2d Sess. (1934) (testimony of Tommy Corcoran).)
Why were our securities law forefathers so insensitive to this issue? They weren’t. They simply understood that the misuse of nonpublic corporate information by corporate insiders was an issue addressed by corporate law, governed by state law corporation statutes or common law principles. The courts were in the midst of addressing the circumstances under which a corporate insider’s securities transaction based on nonpublic corporate information violated any duties or provided the other party to the transaction, or the corporation itself, grounds to assert a cause of action. In 1909, the Supreme Court ruled in Strong v. Repide, 213 U.S. 419 (1909), that a shareholder approached by an insider to sell her shares when the insider knew about, but kept secret, business negotiations that would enhance the value of those shares, could have a cause of action even though the insider technically did not owe fiduciary duties to the shareholder (as opposed to the company). State courts ruled in varying ways on such claims, in part depending on the specific facts of the interactions, if any, between insiders and shareholders. Those courts were sensitive to the concern that “An honest director would be in a difficult situation if he could neither buy nor sell on the stock exchange shares of stock in his corporation without first seeking out the other actual ultimate party to the transaction and disclosing to him everything which a court or jury might later find that he then knew affecting the real or speculative value of such shares.” Goodwin v. Agassiz, 283 Mass. 358, 362,186 N.E. 659, 661 (Sup. Jud. Ct. Mass. 1933).
In 1934, Congress was well aware of the fact that some corporate directors and officers “used their positions of trust and the confidential information which came to them in such positions, to aid them in their markets activities.” S. Rep. No. 1455, 73rd Cong., 2d Sess. (1934). It ultimately concluded that the best approach to that problem was not to enact a federal law barring such trading, but to require prompt disclosure of insider trades so the public could learn of them, and provide that the corporation was entitled to recover profits from short-swing trades under section 16. See H.R. Rep. No. 1383, 73rd Cong., 2d Sess. (1934). Even so, it was well-understood that “the unscrupulous insider may still, within the law, use inside information for his own advantage.” Id. So, even though the chief antifraud provision of the 1934 Act, section 10(b), was incorporated into the original statute in essentially the same form it takes today, it was generally understood that the “manipulative or deceptive device[s]” it prohibited did not bar corporate insider trading.
Although state law on this issue continued to vary in the ensuing years, it was recognized in the key corporate law jurisdiction of Delaware that officers, directors, or employees of a corporation who profit from the use of proprietary corporate information in securities trading, whether or not they owe a “fiduciary duty” to refrain from such trading, can be required to pay the corporation any profits from such trading in an action for disgorgement. See Brophy v. Cities Service Co., 70 A.2d 5 (Del. Ch. 1949). The concept is that it is the corporation, not the counter-parties to the trades, to which a duty may be owed, and which is harmed by the unauthorized use of confidential corporate information. This remains a valid corporate claim to this date.
It was not until many years later that the concept was introduced that a “fair and honest market” incorporated some sense of equal opportunity for investors to profit on securities trading, and that a person may be precluded from trading if he or she has an informational advantage. And this was not legislated, it was announced by the SEC in an enforcement fiat (not even an administrative rulemaking), and then promoted and advanced by federal courts which elevated their concept of investment egalitarianism above the state laws that normally govern the relationships and duties between corporate officers, directors, and shareholders.
It is reported that when William Cary was appointed SEC Chairman in 1961 (27 years after enactment of the 1934 Act), it was near the top of his agenda to have the SEC effectively overturn Goodwin v. Aggasiz. The fact that this was a long-standing matter governed by state law was, in his view, unfortunate. Chairman Cary personally found it “shocking for either courts or business executives to believe that it was permissible conduct for executives to use inside information for their personal benefit,” and was committed to using the SEC to create federal law “guaranteeing, as far as the law could, that all investors trading on stock exchanges have relatively equal access to material information.” (J. Seligman, Memories of Bill Cary, The CLS Blue Sky Blog, Jan. 24, 2013) (see link to the right).
Bill Cary did, in fact, lead the SEC down a new path enshrining equal access to information as the “Holy Grail” of securities markets. He did this in an administrative enforcement proceeding involving a broker who sold shares of stock for clients after being told by a Board member that the company had reduced its dividend, but before that news was released to the public. In the Matter of Cady, Roberts & Co., 40 S.E.C. 907 (1961). Cary effectively ignored corporate state law, as well as the plain history of the 1934 Act, when he envisaged the federal securities acts as generating “a wholly new and far-reaching body of federal corporation law” (id. at 910), something well beyond the articulations of Tommy Corcoran and the 73rd Congress. Cary went on to declare: “We, and the courts, have consistently held that insiders must disclose material facts which are known to them by virtue of their position but which are not known to persons with whom they deal and which, if known, would affect their investment judgment.” Id. at 911. He cited three district court cases in the previous 27 years, but acknowledged in the same footnote that this was not, in fact, the “majority” rule. Id. at 911 n.13. He went on to announce that there was an “inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing” (id. at 912), and that it did not matter that the transaction occurred in an impersonal exchange because “[i]t would be anomalous indeed if the protection afforded by the antifraud provision were withdrawn from transactions effected on exchanges.” Id. at 914. After all, he reasoned, we can assume these investors would not have offered the same price if they had known of the negative nonpublic information. Id.
In one fell swoop, the SEC promulgated (without notice or comment) a new “federal corporation law” governing trading by officers or directors on nonpublic corporate information, and overturned years of state law holdings that officers and directors owed duties to the corporation, but not to shareholders, in impersonal open market transactions. And he did so without any effort to analyze how these new legal precepts might affect the balance of power between federal and state authorities over corporate conduct, or how it might impact overall pricing of securities in the marketplace (by withholding from the market buy and sell transactions needed to move market price to a “fair” valuation of the security). In short, in Cady, Roberts the SEC (1) elevated the desire for equal access to information above the need for fair pricing of securities on the exchanges, and (2) elevated its own views on this issue above contrary state law, all without any legislative act endorsing these choices.
As noted, the federal courts generally welcomed the opportunity to follow the SEC’s lead. The influential Second Circuit Court of Appeals took on the issue in the landmark case SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968). The case involved stock purchases by insiders after they learned of a potential large mineral discovery on company property, but before that information was disclosed to the public. The SEC brought an enforcement action alleging this trading was fraudulent under section 10(b), and sought to compel rescission of these transactions. The district court tried the case and found liability on some section 10(b) claims (ruling against others on materiality grounds). The appellate court affirmed the section 10(b) violations (and reversed the finding of immateriality on other claims). In doing so, the court adopted a broad legal standard endorsing the equal access to information theory in Cady, Roberts.
Right out of the box, the court stated a new vision of what section 10(b) was about, saying: “By that Act Congress purposed to prevent inequitable and unfair practices and to insure fairness in securities transactions generally, whether conducted face-to-face, over the counter, or on the exchanges…. Whether predicated on traditional fiduciary concepts … or on the ‘special facts’ doctrine [of Strong v. Repide] … Rule [10b-5] is based in policy on the justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information…. The essence of the Rule is that anyone who, trading for his own account … has ‘access … to information intended to be available only for a corporate purpose and not for the personal benefit of anyone’ may not take ‘advantage of such information knowing it is unavailable to those with whom he is dealing,’ i.e. the investing public.” 401 F.2d at 848 (quoting Cady, Roberts). The court then announced a so-called “disclose or abstain” rule: “Thus, anyone in possession of material inside information must either disclose it to the investing public, or … must abstain from trading….” Id. This single pronouncement, which did not even purport to be anchored in any statutory underpinning, became the foundation of “equal access to information” insider trading dogma for the next 50 years. To drive home its New Order and revisionist history, the court later restated: “The core of Rule 10b-5 is the implementation of the Congressional purpose that all investors should have equal access to the rewards of participation in securities transactions. It was the intent of Congress that all members of the investing public should be subject to identical market risk…. The insiders here were not trading on an equal footing with the outside investors.” Id. at 851-52.
Texas Gulf Sulphur became the rallying point for proponents who supported more and more extensive legal standards to assure that the Holy Grail of equal access to information for all securities investors could be approached, if not fully achieved. The law of “insider trading” would be expanded in leaps and bounds, usually at the behest of the SEC. The distinction between insiders and non-insiders was effectively obliterated, laying waste to the concepts of fiduciary duty which even Cady, Roberts and Texas Gulf Sulphur nodded to as the foundation for their extensions of the law. “Tippees” were deemed to violate the insider trading prohibition even though they plainly owed no fiduciary duty to either the corporation about which they possessed nonpublic information or the person who happened to be on the other side of their securities trade. What legal theory was used to support this extension of the law? No more was required, said the SEC and the courts, beyond the “abstain or disclose” rule pronounced in Texas Gulf Sulfur, and the outrage that would occur if these tippees were permitted to gather profits based on nonpublic information not available to other market participants. The mere possession of this information created a “duty” — essentially out of thin air — by the tippee not only to the “actual” person on the other side of the transaction, but “to all persons who during the same period” were on the other side of similar transactions. Shapiro v. Merrill Lynch, Pierce Fenner & Smith, Inc., 495 F.2d 228, 237 (2d Cir. 1974). The Shapiro decision even created a private cause of action for all of those people against the tippee, without deigning to explain how someone merely in the vicinity of a transaction should be entitled to compensation for his or her unwise investment decision.
Shapiro is a fine example of how far the courts strayed from any anchor in the law, and their complete disregard for the key role of unequal information in achieving fairly-priced markets. That court expanded the law to create a “disclose or abstain” duty for tippees merely because they “knew or should have known” that information they received originated from a confidential corporate source. Id. at 239. It also gave the back of the hand to the long-standing concept, going back at least to the Supreme Court decision in Strong v. Repide, that the liability of an insider to a counterparty in a securities transaction must be founded on facts showing a special relationship between them that created a duty to disclose. Id. at 239. And, in the court’s own words, the rationale supporting this upheaval in the law was “based chiefly on our decision in SEC v. Texas Gulf Sulphur … where we stated” the abstain or disclose rule. Id. at 236. In deference to a “disclose or abstain” rule the court itself created, and “the strong public policy considerations behind” that rule, the Shapiro court scorned legal arguments founded in long-standing state law principles simply because they “would make a mockery of the ‘disclose or abstain’ rule.” Id. The fact that Congress never suggested, and plainly did not enact, a “disclose or abstain” rule was not worthy of mention. The New Order was to be founded purely on the “strong public policy considerations” anointed by the Texas Gulf Sulphur court.
The Shapiro (and Texas Gulf Sulphur) courts “enacted” the Cady, Roberts “equal access to information” concept of market fairness in complete disregard of economic market principles. The chosen “policy considerations” of the SEC and the Second Circuit focused on populist visions of equality among investors rather than economic principles about how fair and efficient markets function.
This was made plain in Shapiro, in which the court actually held that it was harmful for the securities markets to move toward a fair price for a security. In its zeal to assure that no investor should profit from nonpublic information (which, to repeat, was not what Congress envisioned), the court turned upside down the concept of market integrity. The court accepted allegations that the sales of stock by tippees with negative inside information caused a substantial drop in stock price days before the information was made public, and concluded that this stock price impact undermined the “integrity and efficiency” of the market. But exactly the opposite is true. A “market” has neither integrity nor efficiency when trading occurs at artificially high prices — prices that remain elevated while the holders of secret information are not permitted to assist in bringing the value of a security to its economically justifiable level. The tippees in Shapiro may have lacked personal integrity when they opted to trade based on this information, but they surely assisted in improving market integrity and efficiency by starting the process of bringing stock valuation to levels fairly reflecting the true value of the security. The court lingered on, and created a claim for compensation for, investors who bought the stock before its price declined, but ignored the fact that in the absence of the tippees’ trading, many additional investors would have suffered by being limited to a market that maintained an artificially high stock price for the security they bought. The court found it better that all investors should pay the artificially high price until the earnings information was released publicly. When the tippee arbitrageurs bid that price down, the market as a whole benefited, but the court chose not to consider that “public policy consideration.” From the standpoint of the law, the court had no business imposing an idea of fairness that, as we have seen, had no foundation in the statute it was purporting to apply.
In Part II, we will look at how the Supreme Court started the pendulum swinging away from the New Order of “equal access to information” by returning to statutory principles, and the SEC’s persistent efforts to push back.
May 7, 2014
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