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Enforcing Insider Trading Laws—Confusion Compounded

This is a guest post from Henry G. Manne, Dean Emeritus of the George Mason University School of Law and Distinguished Visiting Professor at the Ave Maria School of Law.

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If rank amateur financial scam artists like the recently arrested Garrett Bauer and Matthew Kluger (the guys who transmitted cash from insider trading to co-defendants in ATM paper envelopes and who never hid money off shore) could operate an insider trading ring for 17 years and make over $34 million before getting caught, how well must the really smart traders be doing? But this most recent insider trading prosecution, like others before it, is touted as a great policing success by the SEC.

What chutzpa! Seventeen years and 34 million in profits would seem to anyone else to be an arrant failure of efficient enforcement. In truth it merely demonstrates the woeful inability of enforcement officials to cope with insider trading, much less understand it.

But, for all the vaunted new detection technology (mostly wiretaps and abusive intimidation), the facts necessary to win cases are not at all easy to ferret out. And even when they are discovered, the law is so unclear as to defy easy convictions, and this in spite of the numerous terror-stricken guilty pleaders.

For example, a wide open question after nearly fifty years of insider trading jurisprudence is whether the proper legal test is trading “based on” material nonpublic information or trading conducted “while knowingly in possession of” such information, a distinction upon which the Galleon Group case may rest. For that matter no one even knows with anything like the certainty required in other areas of criminal law what is even meant by such legally critical words as “material nonpublic information” or stock trading “based on” such information.

As the defense began its phase of the criminal trial of Raj Rajaratnam a few weeks ago, an issue was whether Professor Gregg Jarrell, former Chief Economist for the SEC, would be allowed to testify about trading based at least in part on information that was already public at the time of Rajaratnam’s alleged derelictions.

Such legitimate trading would negate any easy implication that the trade was “based on” illicit information. The “in possession” test, to the contrary, would render such testimony largely irrelevant, and possibly inadmissable, if in fact he did possess nonpublic information. The judge did allow Professor Jarrell to testify, but the legal issue must remain basically unsettled until it is resolved by an appellate court.

But even if the law generally accepts the more defendant-friendly “based on” test, hard legal questions will remain. Consider a situation in which a trader has done legitimate analysis of a security and believes, with 50% confidence, that the company will soon be a takeover target and with 50% confidence that the stock price will decline. No transaction is indicated. Now suppose that an unreliable tipster (right only 10% of the time) calls in with admitted inside information that a takeover deal is imminent. There may be several ways of calculating the new level of confidence, but in any event it is above the 50% level, and a buy is now indicated.

Was this trade “based on” the inside information, or was it based on the legitimate research? This can be seen as an unresolvable philosophical conundrum, and not surprisingly there is legal dictum on both sides of the question. And what is the measure of “based on?”

Is it “predominantly based on” or “significantly based on” or “measurably based on?” Who knows?

This hypothetical suggests a related topic on which there is also no clear law, the so-called “mosaic theory of investment,” also perhaps central to the Galleon case. This situation is implicated fairly regularly when a stock analyst combines a number of small bits of both public and nonpublic information to reach a confident trade recommendation about a stock, even though not a single one of the bits of information standing alone reaches the level of materiality required for an insider trading violation. Indeed, anyone not steeped in the SEC’s peculiar logic would think that this is what stock analysts were supposed to do

The foregoing discussion presents a microcosm of the many problems attending the policing of insider trading laws (and perhaps inadvertently demonstrates why the securities bar is so overwhelmingly in favor of insider trading regulation) and gives some sense of why the government has such a low success rate in its insider trading prosecutions. But such less-than-perfect policing has unique adverse economic consequences that are revealed in both of the current cases.

The phrase “insider trading” suggests trading by those intimately involved with a corporation’s management, those most immediately privy to the significant information that could allow a killing in the stock market. Ironically, however, ever since the groundbreaking Texas Gulf Sulphur Co. case of 1968, very few enforcement actions have involved these real insiders. Top executives and directors of publicly held companies know that they would be easy targets for prosecutors, and they have a lot more than a limited stock market profit to lose if they are caught. Our insider trading laws have probably been quite effective in inhibiting informed trading by real corporate insiders.

But others, perhaps like the current defendants, will not be as risk averse as executives slugging their way up a management hierarchy or those at the top. Their risk-reward calculation will be quite different for organizing new channels of information flows and then trading on information that is not being used by real insiders. When it takes 17 years to catch amateurs and when the applicable law is so confused that acquittals and decisions not to prosecute far outnumber convictions, the bet will look like a good one to these outsiders.

Empirical studies have made it clear that they are likely present in large numbers.

This transfer of information to outsiders hides considerable costs to shareholders. The valuable incentive effects for real insiders to produce good news are lost. And since a right to trade on nonpublic information has a real value that is not paid by the company’s shareholders, its prohibition, in a competitive market, requires a substitute payment in another form, one that will show up on the company’s bottom line. It makes more sense to stop this prosecutorial travesty with its perverse results and regain for investors some of the many benefits of a free market in valuable information.

Henry G. Manne is Dean Emeritus of the George Mason University School of Law and Distinguished Visiting Professor at the Ave Maria School of Law.

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