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Congressman Thinks Maybe 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 strange but well-known fact about insider trading is that there's no law against it. There's a law against securities fraud: You can't use "any manipulative or deceptive device or contrivance" when you're trading securities, and that law authorizes the Securities and Exchange Commission to make specific rules to prevent fraud. But there's no general SEC rule against insider trading either.  Insider trading is a crime created and almost entirely defined by the courts, and people go to prison for years for violating a law that isn't written down anywhere and whose contents are hotly disputed. 

But since courts created insider trading, they can change what it means, and in December they did: The U.S. Court of Appeals for the Second Circuit, in U.S. v. Newman, reversed two insider-trading convictions, holding that prosecutors had overreached in their recent barrage of insider-trading cases and making it more difficult to prosecute future cases.

This led some people to think that Congress should act to ban insider trading. (Other people were more skeptical of Congress's skills and good faith in this area.) And now Congress has -- well, not obliged, but at least taken a step toward obliging: Representative Stephen Lynch of Massachusetts "recently introduced H.R. 1173, the Ban Insider Trading Act of 2015." 

I know nothing about Congress, but my working assumption is that any proposed bill is mostly a joke that I am too unsophisticated to get, so that's probably what's going on here. But the bill does represent one end of the spectrum of plausible future regulation: the current regime, represented by the Newman decision, is about as lenient an insider-trading regime as we are ever likely to see again, while Lynch's bill is probably the maximum of what might be criminalized. So it's worth talking about the bill even if, as I suspect, it's not going to pass.

Lynch's bill would make it illegal to trade "based on information that the individual knows or should know is material inside information," according to his press release. There are three innovations in that sentence; let's take them in reverse order.

First: "inside information." Oddly enough, that phrase is a novelty; the crime we now call  "insider trading" is defined in terms of "material nonpublic information," with the word "inside" not having much legal meaning. But in the proposed bill, which you can read here (it's short), "inside information" is central, and it's defined:

The term "inside information" means information that is --

(i) nonpublic; and

(ii) obtained --

(I) illegally;

(II) directly or indirectly from an issuer with an expectation of confidentiality or that such information will only be used for a legitimate business purposes; or

(III) in violation of a fiduciary duty.

So what's new here? The current law  is that you can't trade on information that you got in breach of a "duty of trust and confidence." Clause (ii) here -- technically it seems to be proposed section 10(d)(3)(A)(ii) of the Securities Exchange Act -- is a similar rule, but specified in a different way, with some good news and some bad news and some just unclear news for prospective insider traders.

The good news: A "duty of trust and confidence" is not an especially well defined thing in the current law. Insider trading law finds duties of trust and confidence where no other laws impose any duties. Most notably, the SEC thinks that golf buddies and roommates have a duty of confidentiality to one another. This is not a duty that is otherwise imposed by law, or even by the rules of golf or most apartment leases, though perhaps individual golf clubs have their own codes of secrecy, I don't really know. It does seem odd for criminal liability to come from these amorphous duties that are not otherwise recognized in the law.

But a "fiduciary duty" is actually a thing in the law. You can know in advance whether or not you have a fiduciary duty to someone. Whatever a "duty of trust and confidence" is, and whether or not roommates and golf foursomes have it, they definitely don't have a "fiduciary duty" to one another. So if you play golf with a billionaire, and he tells you that he plans to acquire a company, you can probably use that information. If you see your roommate working on an Herbalife short presentation for his hedge fund, you can go ahead and trade on it.  That is, for potential traders, an improvement over current law.

On the other hand, there are some bad points too. One minor one: Material nonpublic information obtained "illegally" is also "inside information" under the bill's definition. This seems trivial, but solves a puzzle that I have occasionally pondered: Under current law, if you hack into a company's computers and steal its information and trade on it, is that insider trading? Probably, yes -- it certainly sounds bad -- but I don't think it fits neatly under the language of the main insider-trading cases. [Update: It fits in this one, though! Answer: Insider trading. I wasn't too worried.]

But the main bad news is in section 10(d)(2)(B), a "rule of construction" saying that the new bill does not require "a personal benefit to any party." This is a direct response to the Newman decision. The current law is that it's only insider trading if the insider breaches his "duty of trust and confidence" in exchange for a personal benefit: If he just tells you about a merger for no reason, and you trade on it, it's not insider trading. For a long time, this rule didn't much limit prosecutions -- everyone has some reason for doing things, and a vague feeling of benevolence is a kind of personal benefit -- but the Newman court revitalized it, holding that the tipper has to get a personal benefit "of some consequence" to make it illegal insider trading. In Newman itself, where the corporate insiders got nothing more than generic career advice, the court found no personal benefit, and so no crime. Lynch's new bill would get rid of that requirement, and make it easier to prosecute people who trade on insider tips without inquiring into the motivation of those tips.

And then there is the heart of the "inside information" definition: It includes information acquired "directly or indirectly from an issuer with an expectation of confidentiality or that such information will only be used for legitimate business purposes." That's a weird one! What it clearly does is address the classic golf-with-the-CEO problem. Company's chief executive officer plays golf with buddy. CEO tells buddy his company is getting acquired. Buddy trades. Under the Newman decision, that's a tough case to bring, because you can't prove that the CEO got any personal benefit from tipping his golf buddy. Under this bill, the information comes from an issuer (his employer), with an expectation of confidentiality, and the golf buddy knows or should know that, so he can't trade.

So that's clear enough, and addresses the main problem that people seem to have with Newman. But there's plenty of murk here too. "Legitimate business purposes" is a phrase that assumes away a lot of trouble. Take Pershing Square's and Valeant's team effort to buy Allergan, in which -- let's say -- Valeant told Pershing Square about its intention to acquire Allergan in a merger, and Pershing Square went out and bought 9.7 percent of Allergan's stock to facilitate that deal. Pershing Square bought stock based on material nonpublic information about the intentions of Valeant ("an issuer," though not the issuer of the stock Pershing Square bought). That enraged a bunch of people, but it's not insider trading under current law, because Valeant gave Pershing that information and intended it to trade on it.

Is it insider trading under this bill? Probably not? But I don't know? Pershing Square got the information because Valeant wanted it to trade, so it seems like it should be able to trade on the information. On the other hand, Pershing Square's trading did enrage a lot of people, so perhaps that means that buying this toehold to help Valeant's bid was not a "legitimate business purpose"? Who gets to define "legitimate"? The bill doesn't offer much guidance one way or the other.

This is all further complicated by the tender-offer insider trading rules, which are still stricter: Anyone (other than the offeror) who trades on nonpublic information from anyone about a tender offer is guilty of Rule 14e-3 insider trading, no matter who intended what to be kept confidential or used for what purposes. Even under Lynch's bill, the general ban on insider trading won't be that strict, meaning that some kinds of insider trading on acquisitions will still be crimes or not crimes depending on whether the acquisitions are structured as tender offers or as mergers.

So that's "inside information." Next: "material." "Material," in current law, means that there's "substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available." Here's how the bill would define it:

The term "material information" means information that relates, directly or indirectly, to an issuer or a security, and that, if it were made public, would be likely to have a significant effect on the price of a security.

So is that a higher or a lower standard? On the one hand, there's no vagueness about the "total mix," and about reasonable investors' feelings, which honestly seems a bit passé. Markets are efficient, haven't you heard, and the proposed rule is all about price. (And about significant price changes.) On the other hand, there's no requirement of reasonability, and there's the continuing use of "an issuer" and "a security," with no requirement that the issuer and the security be connected. So to take one of my favorite insider-trading hypotheticals: If you learn inside information about Nest (an issuer), does that stop you from trading in the stock of Nestor (a security) (whose ticker is NEST)? My own view -- which not everyone agrees with -- is that the current materiality standard would have a tough time finding news about Nest material to Nestor shares, because no reasonable investor would connect the two based solely on the name. But this bill would get rid of that problem (or whatever it is), and focus solely on predictable price moves. If you know stuff about Nest, and you know that will make Nestor stock go up, you can't trade Nestor stock, even though none of it makes any sense.

Finally, there is "knows or should know." The proposed bill bans trading "based on information that the person knows or, considering factors including financial sophistication, knowledge of and experience in financial matters, position in a company, and amount of assets under management, should know is material information and inside information."

What a bizarre list! Obviously "position in a company" is relevant to whether you should know if you have inside information about that company. (If you're the CEO, you probably do.) But "amount of assets under management"? Which way does that even cut? Like, if you run $20 billion of money, you've probably been told not to trade on inside information a bunch of times. On the other hand, you are probably a bit abstracted from the individual data points that go into a decision to buy or sell a stock. If Steve Cohen were charged with insider trading under this bill, would he have as a defense, "I had too many assets under management, I couldn't have insider traded"?

No, right? The intent here seems to be to presume guilt from sophistication: The more you know about finance, the more you should know that your information is inside information. That is a wildly popular view of insider trading: that the goofballs exchanging tips at golf clubs are just the tip of the iceberg, and that sophisticated hedge funds with, you know, asssets under management are the real insider traders, who cover their tracks by creating plausible deniability about whether their information actually comes from corporate insiders. This does not seem like a particularly well-founded model, and I worry a little bit about enshrining it in law. The more assets you manage, this bill says, the more suspicious your trading will be. If you make money trading stocks, it must be because you have information -- and the more money you make, the more you ought to know that your information is illegal. 

Also Lynch's bill says that anyone who "intentionally discloses without a legitimate business purpose" inside information to another person is guilty of insider trading, meaning that if you come home after a long day at work and tell your spouse that you're working on a merger, bang, off to prison with you. (Whether or not your spouse trades, or tells anyone else.) That seems like it will be hard to enforce.

(Updates 10th paragraph of article published March 3 with computer-hacking insider trading case.)

  1. There is however an SEC rule against insider trading on tender offers, and a few rules defining specific aspects of insider trading.

  2. Because there's no actual statute, this law is a bit vague and amorphous, but my summary of the current law is based primarily on the summary on pages 9-12 in the Newman decision.

  3. The SEC has a rule, Rule 10b5-2, that lists some non-exclusive circumstances where a "duty of trust or confidence" exists. The Supreme Court has raised some questions about whether this rule can apply to criminal cases, though.

    By the way, note that the SEC says "trust or confidence"; most of the court cases say "trust and confidence," which makes me think the SEC is trying to sneak in a lower standard.

  4. Right? I'm assuming that the billionaire can move a stock via his personal investing, and that a billionaire is not an "issuer." I'm also assuming that the hedge fund is not an "issuer," which certainly it's not in any colloquial sense, though I suppose hedge fund limited partnership interests are securities, and maybe there's a stretch sense in which it's covered. I'm also assuming that the roommate is not breaching a fiduciary duty by working on his Herbalife presentation at home, which I think is right. 

    Obviously nothing here is legal advice, even if this bill does become law.

  5. Pershing Square and Valeant would dispute this characterization, saying that they actually bought the shares together in a co-bidding entity, which is probably right but not important for our purposes.

  6. There's also sort of a technical error: You can't trade on information that you got with the expectation that it would "only be used for legitimate business purposes." But you can presume that all information from issuers is intended to "only be used for legitimate business purposes"; no one wants to do illegitimate business. It's just that sometimes those purposes include trading. But even if trading is a "legitimate business purpose," the language of the bill seems to prohibit it: You're not allowed to trade on that information, period, even if the information was disclosed with the specific intent that you trade on it. In fact, you can't trade on any information you receive from an issuer, unless you received it from the issuer with the intent that you use it for illegitimate purposes. This looks like a drafting error to me, but perhaps that really is what's intended?

    A more fundamental variant on this question. Take Pershing Square out of the equation. Hypothetical Valeant wants to buy a toehold in Hypothetical Allergan, preparatory to launching a hostile takeover bid. Hypothetical Valeant tells its chief financial officer to buy some stock. The CFO goes to make a trade for the corporate account. Is Hypothetical Valeant insider trading? It has no inside information from Hypothetical Allergan, of course. But it has information from itself -- information that it expects itself to use only for a "legitimate business purpose." And that information will move Hypothetical Allergan's stock. Can it trade on that information? Can any issuer trade on information about its own intentions? Surely the answer should be yes, but the drafting is at least unclear.

    This is the problem that I have with European-style blanket bans on trading on material nonpublic information. Sometimes your own intentions are material and nonpublic, but you should still be able to trade on them.

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

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