Corporate Governance

Insider Trading and Theft (Part 1)

By J. Robert Brown

We discussed briefly the law of insider trading and its application to gifts.  It is a topic relevant to the shareholder community since it goes to the integrity of the markets.  Insider trading is poker with one of the players knowing everyone else's cards.  The game is fixed and when it's fixed, many investors will logically decide not to play. 

The law of insider trading has been a mess since the Supreme Court's decision in Chiarella imposed a fiduciary duty requirement as a precondition for the offense.  As the Court in Dirks later developed, violation of a duty required some type of benefit to the insider, with the opinion strongly suggesting that this had to be a pecuniary benefit.  The case itself was internally inconsistent and had to fill its own gaps, adopting the notion of a "temporary" insider in order to capture persons and entities that clearly had no fiduciary duty and the concept of a "gift" of the information to capture persons who tip but obtain no benefit in return. 

The opinion, however, left a number of holes.  For one thing, it exonerated insiders from tipping information to analysts and other market professionals unless they benefited.  This authorization to engage in selective disclosure is ultimately what necessitated Regulation FD, prohibiting the practice. 

More importantly, the opinion left out from the prohibition on insider trading other categories of persons, most clearly those connected to a bidder.  Since those persons had no fiduciary duty with respect to a target company's shares, their Chiarella and Dirks seemed to exclude them from the prohibitions on insider trading. 

The gap was filled by the invention of the misappropriation theory, one premised on the use of information in violation of a duty of trust and confidence.  Forget that the duty ran not to the injured shareholders but to whomever established the obligation of trust (in most cases, an employer), and forget that the employer could waive the duty, allowing employees to trade in advance of an acquisition, the theory nonetheless filled most of the remaining gaps left by Chiarella and Dirks. 

But still holes exist in the analysis.  The latest one to surface has been the application of Section 10(b) and Rule 10b-5 to persons who steal information and use it to profit in the securities markets.  It involves information improperly obtained that provides an unfair advantage in the securities markets.  We are back to the poker analogy, with the thief knowing each hand because he or she marks the deck.  Common sense says that the thief violates the antifraud provisions by trading on stolen information but as our second post later today will explain, the law is less than clear and the one case to squarely address the issue concluded that it does not. 

Full post as published by The Race to the Bottom on April 25, 2008 (boomark / email).