Menendez and Reed, sharing some information.

Photographer: Tom Williams/CQ Roll Call

Senators Really Think Insider Trading Should Be Illegal

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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A little while back we discussed the possibility that Congress would pass a law banning insider trading, which is currently illegal based only on a series of court decisions. I was not optimistic:

The obvious rule is: "It is illegal to trade on any information that the rest of the market doesn't know." You and I know that that's a terrible rule, but there's no guarantee that Congress does. It sort of sounds good. And limiting it sensibly is not as easy as you might think. 

So it was a pleasant surprise when Representative Stephen Lynch of Massachusetts introduced a bill that didn't just say that. Lynch's bill was a pretty interesting effort, and I wrote about it at some length last week, and I guess I got a little carried away and said that it "is probably the maximum of what might be criminalized." Why did I say that? I already knew the obvious rule, and the obvious rule is also the maximal rule, and here it is!

Seeking to improve the fairness of our securities markets and crack down on harmful insider trading, U.S. Senators Jack Reed (D-RI) and Bob Menendez (D-NJ), two senior members of the Senate Banking Committee, today introduced the Stop Illegal Insider Trading Act to establish a clear statutory prohibition against insider trading.

Here's the text of the bill, but it's pretty short. It makes it illegal:

(d)(1)(A) To purchase, sell, or cause the purchase or sale of any security on the basis of material information that the person knows or has reason to know is not publicly available.

(B) To knowingly or recklessly communicate material information that the person knows or has reason to know is not publicly available to any other person under circumstances in which it is reasonably foreseeable that such communication is likely to result in a violation of sub-paragraph (A).

There are two important exemptions. One is that the Securities and Exchange Commission can make rules exempting some transactions from the broad prohibition; the other is:

(2) For purposes of this subsection, the term "not publicly available" shall not include information that the person has independently developed from publicly available sources.

That's about it! Like I said, you know and I know that this is a terrible rule, though I guess paragraph (2) makes it a little more tolerable. So for instance if you go to the library, or to Google, and do a bunch of research on Apple, and from that public information you independently develop the information that it's a great little company and you should buy it, then you can buy the stock.

More than that: If Carl Icahn does the same thing, and independently develops the information that he should buy Apple, then he can buy the stock, even though his purchases of Apple stock are, by themselves, enough to move the price of the stock, and therefore material information. But if Carl Icahn told you that he was planning to buy Apple stock, you couldn't buy the stock, because you know something (his intention) that is material and that the market doesn't know. Under current law, if Icahn told you, "I'm about to buy Apple and you should too," you probably could. Arguably that's the point of his Twitter feed. 

What else couldn't you do, under this regime? Oh, lots of things. For instance: Could you fly a helicopter over an oil tank and peek to see how much oil is in it? Could you camp outside the offices of a potential takeover target and see if anyone interesting walks in? Could you talk to a company's customers to see if they're increasing their orders? Could you pay for a stock exchange's depth-of-order-book information if it only makes its top-of-book information available for free?

More generally, could you use information that you have not yourself "independently developed from publicly available sources," even if someone else has? Could you ask a doctor what she thinks about a drug company's new drug? Not a doctor involved in the drug trials, I mean; just a doctor. Her opinion, even though it's based on public information, isn't public: Can you consult it? Could you ask a geologist about an oil company, or an engineer about a wireless company?

Could you even read investment bank research? Is investment bank research "publicly available"? Not everyone gets it, after all. You notionally have to be a client to get research, which can move prices (material!) and is "developed from publicly available sources." This seems like a dumb gotcha -- surely these senators don't actually mean to ban research -- except that here's their reasoning:

"Insider trading puts the average investor at a disadvantage and reduces both public trust and confidence in our markets.  Cracking down on unlawful insider trading should be a bipartisan priority," said Senator Jack Reed. 

And:

"Insider trading makes our markets less fair, hurting families’ ability to save and deterring regular investors from entering the market," said Senator Bob Menendez.  

Obviously not all families and average investors have access to every bank's research. Isn't that unfair to them?

The news release also says:

In addition, the proposed bill takes care to ensure that those who take the time and the effort to independently develop their own information from publicly available sources can trade on this independently developed information, so that publicly available information can be analyzed and interpreted without fear of liability.  

But it doesn't! It just says the thing I quoted, paragraph (2), asserting that. But if you consult experts or talk to other investors or do research outside of Google, you will always need to worry that your information is not public enough, and that you will go to prison. Maybe you won't actually end up with criminal liability, but you can't do anything without fear of liability. Everything is vague; every trade is a possible crime.

Now many particular cases of information advantages -- expert networks, exchange data fees, cameras in helicopters, hedge-fund guys sharing trades with other hedge-fund guys, even differentiated access to sell-side research -- might be controversial. In isolation, any one of them might seem unfair, and you might want to crack down on it. 

But this bill would ban all of them, all at once, so let's not think of them in isolation. What do they add up to? I guess if you're a politician you'd say: They add up to an unfair market that puts regular families at a disadvantage. This is self-evidently dumb; regular families should be at a disadvantage in trading individual stocks, relative to someone whose full-time job is trading stocks. That's what professionalization means: If you do something as your job, you really ought to be better at it than a casual amateur.

If you're an investing professional you'd say: These information advantages add up to the profession of investing. The point of investing is trying to get information that other people don't have, and use it to buy and sell securities. That's how markets work: People who want to make money trading securities have an incentive to find out information, and then use it to buy and sell securities, which causes the prices of those securities to incorporate that information, which makes markets efficient. Which makes it safe for regular families to invest: They know that if they buy Apple stock, its price incorporates all the information that people in the market can ferret out, and so reflects Apple's prospects as fairly as possible. If you make it illegal for professionals to seek out information, then the stock price won't reflect that information, and the families will be stuck seeking it themselves. Why would they be any good at that?

  1. I mean, there's some administrative cleanup, but that's all the substance. Unlike Lynch's bill, there is no effort to define materiality, to define "inside information," etc. Nor does it try to define "publicly available."

  2. Neither legal nor investing advice!

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net