After my piece arguing that newspapers selling scoops to hedge funds would be violating insider trading laws, a number of people pointed out that my argument only took into account the “classical” theory of insider trading and left out what’s known as the “misappropriation theory.”
That’s very true. I didn’t write about misappropriation theory—because it just doesn’t apply here.
In the years since the Dirks case, the federal courts have adopted a broader approach to insider trading law known as the “misappropriation theory.”
The concept is used to catch outsiders who have access to information that could move a stock's price, but who don’t owe any duty to the shareholders of the company traded.
The most famous misappropriation case—and the most relevant here—is probably the Foster Winans case. Winans was a Wall Street Journal reporter who wrote the paper’s "Heard on the Street" column. At trial, Winans was convicted of engaging in a conspiracy to tip off his stockbroker and his roommate about Heard stories that were in the works. Those guys then used the information in stock market trades, front running the column.
The Second Circuit held that Winans' breach of the Journal's policy against leaking confidential information created a corollary duty to abstain from trading based on that information. Winans had misappropriated the information from the Journal, converting it to private use.
Attorneys for Winans argued before the Supreme Court that although their client had violated the rules of the Wall Street Journal by leaking the columns to his friends, he hadn’t done anything in violation of securities laws. He wasn’t an insider at the companies he was writing about, and he wasn’t passing along inside information about the companies. He had no fiduciary relationship with the shareholders of the companies he was writing about.
The court deadlocked 4-4 over Winans case, upholding his conviction but not ruling on the misappropriation theory. Nonetheless, approval for the theory came years later in another case, United States v. O’Hagan. There, the court left no doubt that an employee of one company could be convicted of insider trading for trading the stock of another company.
The key to misappropriation theory is that an employee’s undisclosed and self-serving use of information belonging to his employer to trade securities is a securities fraud. The employee is “misappropriating” the information from his employer and using it for his own personal gain.
It seems pretty clear that if the Winans case were heard after O’Hagan, the court would easily have found that insider trading in violation of Rule 10b-5 had been committed.
But it is equally clear that if the Wall Street Journal had authorized Winans to leak to his roommate and his stockbroker, no violation would have occurred. In that case, there would be no breach of duty to his employer, which means there’s no misappropriation.
To return to Felix Salmon’s example, The New York Times is perfectly free to sell early access to its scoops to “elite” subscribers—and the subscribers are perfectly free to trade on that information. New York Times reporters, however, could not sell the scoops on their own since this would violate company policy.
The Supreme Court even said as much in the Winans case.
“The confidential information was generated from the business, and the business had a right to decide how to use it prior to disclosing it to the public,” Justice White wrote in the Winans opinion.
In short, the misappropriation theory just doesn’t apply to a case when a newspaper sells its own scoop. It is the principal rather than the fiduciary. It can clearly authorize itself to sell the scoop.
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