My colleague JW Verret has an interesting take on the bank bailout at Forbes.com:

This deal was intended to bolster public confidence in banks, while at the same time minimizing the cost of the bailout when Treasury sells its shares once markets pick up. The form of equity Treasury has taken, and plans to take in the second round of the bailout, threatens to destroy both goals.  This is because governments have two unique qualities: immunity from insider trading laws and a political interest in using their shareholder power to pander to special interests.

A healthy share price makes for a healthy bank. But healthy share prices require healthy profits. When governments become powerful shareholders in companies, the profit motive is inevitably watered down.

After European governments privatized government-run industries in the 1980s they maintained powerful equity positions in the privatized firms. Those companies were twice as likely to need to subsequently obtain subsidies and bailouts at the public trough.

***

Another important consequence of the bailout is that Treasury’s access as a regulator to inside information about banks makes it the ultimate inside trader of stocks in financial institutions. Luckily for the federal government, it has sovereign immunity from insider trading laws.

The market will significantly discount the value of banks in which Treasury is a shareholder. Since the dominant player in that market has the opportunity to engage in insider trading, it makes little economic sense for other investors to buy bank shares. Why would anyone want to play the game when they know the game is rigged?

To protect against insider trading liability, corporate executives file “10b-5 plans” that detail future share sales. Treasury should be bound to the same kind of plan to assure investors that it will not use inside information to trade its shares.

On the flight back from my spring break ski trip, I had a chance to read the recent Tenth Circuit opinion reversing the insider trading conviction of former Qwest CEO, Joseph Nacchio. Mr. Nacchio had been convicted of 19 counts of insider trading, sentenced to six years in prison (plus two years’ supervised release), fined $19 million, and ordered to disgorge $52 million more. In a 2-1 decision authored by Judge McConnell, the Tenth Circuit reversed Nacchio’s conviction because of the district court’s exclusion of expert testimony by Dan Fischel (my corporations prof). The court also concluded that retrial will not constitute double jeopardy because a properly instructed jury could have found Nacchio guilty of insider trading. To reach that conclusion, the court had to delve extensively into the law of insider trading and the evidence presented at trial.

Here are a few thoughts on the decision.

Fischel’s Expert Testimony

The court was right to insist that Nacchio be allowed to present Prof. Fischel’s expert testimony. The government’s basic claim against Nacchio was that he sold Qwest stock after he learned that the company’s revenues were largely comprised of non-recurring sources, implying that the company would have a hard time meeting projected earnings. Nacchio maintained that he sold the stock not because he was trying to avail himself of an inflated stock price but because he wanted to diversify after he exercised soon-to-expire stock options. He also contended that the specific information to which he was privy (i.e., that much of Qwest’s revenue was non-recurring) was not “material” non-public information because the market didn’t react when the information was publicly disclosed.

Prof. Fischel was to testify (1) that Nacchio’s trading pattern was more consistent with a diversification strategy than with an attempt to profit from inside information and (2) that the stock price effect of the disclosure concerning Qwest’s non-recurring revenue suggested that the information wasn’t material. The district court ruled that Prof. Fischel wasn’t properly disclosed as an expert witness and that, in any event, his testimony wouldn’t “assist the trier of fact.”

I don’t want to get into the expert disclosure rules (where the district court apparently ignored distinctions between the criminal and civil contexts), but it seems clear to me that the district court was just wrong on the question of whether Fischel’s testimony would help a jury. Having taught Business Organizations a few times, I’ve seen that many smart, educated people are not aware of (1) why diversification is so important (and thus why sophisticated investors always diversify) and (2) how stock prices immediately incorporate material information. Fischel’s testimony would undoubtedly help jurors understand Nacchio’s defense. (More on this aspect of the decision from Jay Brown.)

Two Wrongs Don’t Make a Right (…as I said earlier)

One of Nacchio’s arguments was that his knowledge of pending deals with the government — deals that would have boosted Qwest’s revenue — immunized him from insider trading liability. This undisclosed “good news,” he argued, negated the materiality of the undisclosed fact that much of Qwest’s revenue was non-recurring. Moreover, he contended, the fact that he knew this information shows that he did not act with scienter (an intent to deceive).

I previously expressed skepticism about Nacchio’s defense. In a post titled Nacchio’s Puzzling (Innovative?) Defense, I wrote the following:

Is Nacchio claiming that it was OK for him to sell while in possession of material non-public bad news regarding company prospects because he also possessed material non-public good news? Is this a “two wrongs make a right” theory?…

Nacchio’s defense (or this part of it, at least) is that two “wrongs” do make a right because the second piece of non-public information to which Nacchio was privy when he traded (i.e., the likelihood of the lucrative defense contracts) would make the first piece (i.e., various bits of bad news at the company) immaterial. In other words, the theory seems to be that the totality of non-public information of which Nacchio was aware would not be something a rational investor would consider important in deciding how to invest (and thus would not be material), for Nacchio’s private negative information was counterbalanced by private positive information.

…I’m not optimistic for Nacchio.

It seems my skepticism was warranted. Upholding the district court’s decision to prohibit Nacchio from presenting classified information about the alleged government contracts, the Tenth Circuit quickly disposed of the “two wrongs” theory:

[E]ven if the classified information were presented and established what he said it would, it could not exonerate Mr. Nacchio as he claims. Essentially, Mr. Nacchio argued that undisclosed positive information can be used as a defense to a charge of trading on undisclosed negative information. We disagree. … If an insider trades on the basis of his perception of the net effect of two bits of material undisclosed information, he has violated the law in two respects, not none.

An Opening to Challenge Rule 10b5-1

Nacchio claimed that his sales were not illegal insider trading because he did not make them “on the basis of” material non-public information. Even if he possessed such information when he sold his stock, the information, he insists, did not cause the sales; he would have made them anyway in order to exercise his options and achieve diversification. Thus, the sales were not “on the basis” of material non-public information.

If one were to look only to the securities regulations, Nacchio’s position would seem doomed. The SEC’s Rule 10b5-1 states that any securities trade made while “aware” of material non-public information is made “on the basis” of such information, unless the trade was made pursuant to some securities trading plan executed before the trader became aware of the information. Thus, if you possess material non-public information, and you trade, and your trade wasn’t pursuant to some previously executed contract or instruction or “written plan for trading securities,” you’re in trouble.

But that rule would seem to read the “scienter” element out of an insider trading claim. The law prohibiting insider trading, Section 10(b) of the Securities Exchange Act, prohibits only “manipulative or deceptive device[s] or contrivance[s]” that contravene SEC rules. This language would seem to require some intent to deceive (or at least recklessness), and the Supreme Court has interpreted it accordingly. In a prominent insider trading case, Dirks v. SEC, the Court was careful to emphasize that “[t]here must also be ‘manipulation or deception’ in an insider trading case,” and it said the following about the required scienter element:

Scienter — “a mental state embracing intent to deceive, manipulate, or defraud” — is an independent element of a Rule 10b-5 violation. Contrary to the dissent’s suggestion, motivation is not irrelevant to the issue of scienter. It is not enough that an insider’s conduct results in harm to investors; rather, a violation may be found only where there is “intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities.”

(Note 23, citations omitted.)

Thus, it would seem that proof of “intent to deceive, manipulate, or defraud” is required to establish illegal insider trading. Rule 10b5-1 would impose liability without such proof, but that rule, promulgated by the SEC, can’t go further than the authorizing statute, Section 10(b). The rule, then, may be invalid. (For more on this, check out this from Prof. Bainbridge.)

On remand, Nacchio is almost certain to challenge the validity of Rule 10b5-1. Judge McConnell’s opinion invites him to do so. It notes that “[s]ome commentators maintain that [Rule 10b5-1] (the authority of which has not been resolved by any circuit) is unlawful because it effectively eliminates fraud from the liability standard.” Watch for Nacchio’s lawyers to seize on this argument when fighting over jury instructions on remand.

A Lenient Materiality Standard

Finally, the Tenth Circuit’s decision is notable for adopting a very lenient standard for the “materiality” of non-public information. The non-public information at issue in this case suggested that earnings targets were overstated. Nacchio argued that this information was not material because the degree of overstatement was so slight. He contended that the degree of overstatement was 1.4% of total revenues; the government maintained that it was 4.2%. In either event, Nacchio’s argument would seem to be fairly strong. The Tenth Circuit noted that “[c]ourts regularly look to the magnitude of a potential loss in determining whether knowledge of it is material,” and it cited an unpublished Ninth Circuit decision concluding that “[revenue] projections which are missed by 10% or less are not generally actionable.” (In re Apple Computer, Inc., 127 F. App’x 296, 204 (9th Cir. 2005).) It also quoted from an SEC accounting bulletin in which the accounting staff assessed the “common ‘rule of thumb’ among accountants ‘that the misstatement or omission of an item that falls under a 5% threshold is not material in the absence of particularly egregious circumstances.’” In that bulletin, the accounting staff stated:

The use of a percentage as a numerical threshold, such as 5%, may provide the basis for a preliminary assumption that–without considering all relevant circumstances–a deviation of less than the specified percentage with respect to a particular item on the registrant’s financial statement is unlikely to be material. The staff has no objection to such a “rule of thumb” as an initial step in assessing materiality. But quantifying, in percentage terms, the magnitude of a misstatement is only the beginning of an analysis of materiality; it cannot appropriately be used as a substitute for a full analysis of all relevant considerations.

Given the accounting staff’s unwillingness to create a real safe harbor for revenue deviations of less than 5% of projections, the Tenth Circuit was unwilling to conclude that Nacchio’s non-public information about a likely revenue shortfall (which the court measured at 4.2% of projections) was immaterial. So much for the rule of lenity.

(More on the materiality ruling here.)

***

So what’s going to happen on remand? Jay Brown thinks Nacchio’s prospects are pretty grim. I’d perhaps offer a brighter prognosis. If Nacchio can get the court to reject Rule 10b5-1’s “awareness” standard, so that the government must prove that the material non-public information caused the sales at issue AND if Fischel sets forth a convincing case for why the stock trades must have been accomplished as part of a diversification strategy, not as an attempt to profit from inside information, then he has a shot.

Of course, those are some big ifs. Nacchio’s best approach might be a plea bargain. I, of course, hope he doesn’t do so so that a court can directly confront Rule 10b5-1’s overbreadth.

I recently posted on SSRN one of the two articles I have committed to write for the Entrepreneurial Business Law Journal. It’s entitled PIPEs (note that I went with a “micro-title” and successfully resisted the urge (at least for now) of being “very punny,” e.g., PIPE bomb, Sewer PIPE, Burst PIPE, Smoking PIPE, PIPEline . . . .). You can download the piece here. Below is the abstract:

The Article examines Private Investments in Public Equity (PIPEs), an important source of financing for small public companies. The Article describes common characteristics of PIPE deals, including the types of securities issued and the basic trading strategy employed by hedge funds, the most common investors in small company PIPEs. The Article argues that by investing in a PIPE and promptly selling short the issuer’s common stock, a hedge fund is essentially underwriting a follow-on public offering while legally avoiding many of the regulations applicable to underwriters. This “regulatory arbitrage” makes it possible for hedge funds to secure the advantageous terms responsible for the market-beating returns they have garnered from PIPE investments. Additionally, the article details securities law compliance issues with respect to PIPE transactions and explores recent SEC PIPE-related enforcement actions and regulatory maneuvers. The Article concludes that a more measured and transparent SEC approach to PIPE regulation is in order.

I’m hoping to have a related piece about reverse mergers up on SSRN next month.

The insider trading trial of former Qwest CEO Joseph Naccio began yesterday. I’ve posted a couple of times (here and here) on Nacchio’s innovative defense, which the WSJ labeled a “black box” defense. (Basically, Nacchio is arguing that his sales of Qwest stock could not have been based on material non-public information that Qwest was doing poorly because he also had non-public information that Qwest was likely to procure some lucrative government contracts.)

TheRacetotheBottom.org, which describes itself as “a pro-SOX blog,” is covering the trial. Based on the blog’s name and description, I’m guessing its authors’ views on insider trading are somewhat different than my own. In any event, the bloggers are providing an interesting play-by-play.

R. Foster Winans knows insider trading.

A former author of the Wall Street Journal’s Heard on the Street column, Winans was a key figure in an insider trading case that went all the way to the U.S. Supreme Court. In that case, Carpenter v. United States, the Court affirmed securities fraud and mail/wire fraud convictions against Winans, who tipped investors about the contents of forthcoming Heard on the Street columns.

In an interesting NYT op-ed, Winans argues for a rethinking of insider trading policy. He contends that the SEC’s current policy improperly aims at “maintain[ing] fairness” in securities markets. Trading on an informational advantage may be a sin, Winans says, but it really isn’t a crime. Indeed, everyone who trades stock does so because she believes she knows something others don’t — something that causes the stock she’s trading to be undervalued (if she’s purchasing) or overvalued (if she’s selling). Moreover, the only way the SEC can police unfair trading on the basis of an informational advantage is to prosecute selectively, “much as a patrolman tickets only the red sports car when everyone on the road is speeding.” That sort of selective prosecution is troubling, Winans maintains, for “stopping the sports car slows traffic only for a mile or two” and “gives the false impression that the policeman is on the beat, making the financial markets safe for the rest of us.”

Winans thus concludes that the SEC ought to stop fighting sin — i.e., trading on an informational advantage — and redirect its efforts to combatting crime — i.e., insider trading that involves the theft of non-public information. (”The solution is sinfully simple. Throw out the current insider trading laws and bus the Securities and Exchange Commission’s lawyers over to the Justice Department, where they can concentrate on the real crime: stealing.”)

While I’m generally sympathetic, I think Winans glosses over a couple of things.

First, current insider trading policy is not — at least, isn’t officially — based on the achievement of fairness (or a level playing field) in securities trading. It couldn’t be. As Winans notes, practically all trades involve some sort of information asymmetry. Moreover, making it illegal to trade on the basis of an informational advantage would wreak havoc on the securities industry, in which analysts make their livings — and enhance market efficiency — by discovering hidden information and recommending trades on the basis of it. Efficient capital markets are ultimately the best investor protection there is, so any development that impaired securities analysts would ultimately harm investors.

Fortunately, the Supreme Court grasps this point. The Second Circuit flirted with a level playing field-based insider trading regime in the 1969 Texas Gulf Sulphur case (“The core of Rule 10b-5 is the implementation of the Congressional purpose that all investors should have equal access to the rewards of participation in securities transactions. … The insiders here were not trading on an equal footing with the outside investors.”). The Supreme Court, however, squarely rejected the notion that insider trading liability can arise solely because of the unfairness of trading on an informational advantage:

Imposing a duty to disclose or abstain solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market. (Dirks v. SEC, 1983)

Now, Winans may be right that the SEC’s real goal in prosecuting insider trading is to create some sort of level playing field. As a matter of legal doctrine, though, the insider trading ban is not based on ensuring informational parity. In other words, “sinful” trading on an informational advantage is not, without more, illegal.

Second, Winans’ sin versus crime dichotomy is a false one, for it leaves out the actual theory on which the ban is based: fraud. As a matter of official doctrine, insider trading is illegal not because it’s unfair (the sin theory) or because it’s stealing (the crime theory) but because it involves a misrepresentation. Under the classical theory, fraud arises because the trader is a fiduciary of her trading partner, owes that partner a duty to disclose the inside information before trading on it, and fails to do so. Under the misappropriation theory, fraud arises because the trader is in a relationship of trust or confidence with the source of her information and “feigns fidelity to the source of the information” by failing to disclose her trading plans before doing so. (See United States v. O’Hagan, 1997). While the misappropriation theory does seem to involve some sort of stealing (using information owned by a fiduciary), liability is based not on the using of the information but on the failure to disclose one’s intention to do so. As Justice Ginsburg explained in O’Hagan, “[F]ull disclosure forecloses liability under the misappropriation theory … [I]f the fiduciary discloses to the source that he plans to trade on the nonpublic information, there is no [insider trading liability].”

***

All that said, I’m sympathetic to Winans’ basic point that we should reconceive of insider trading as an offense based on theft, not fraud. The gravamen of an insider trading offense is trading on information that doesn’t belong to you, and the only reason the courts have concocted this crazy fraud-based liability scheme (which Saikrishna Prakash has aptly described as dysfunctional) is because the securities laws ban fraud and not theft of information. Congress could easily fix that and would likely do so if the courts would ever own up to the fact that they just can’t force this square peg of theft into the round hole of fraud.

Of course, if insider trading were treated as a property rights violation rather than as fraud, the door would be open for firms to opt out of the insider trading ban. A corporation might say to its insiders (or to some class of them), “We transfer our right to this information to you. You may use this information in making trades.” Would firms really do that? Who knows. We could let the market decide. Firms might find, as Henry Manne famously argued, that the right to trade on inside information is a desirable form of compensation — that their shareholders are better off if executives are compensated with the right to use information rather than with money that could otherwise go to the shareholders. Or they might find, as I’ve argued, that the right to trade on inside information enhances the efficiency of the firm’s stock price, preventing mispricing that can increase agency costs. Or they might find, as Henry more recently argued, that insider trading provides informational benefits that lead to better management.

It’s impossible to say ex ante what firms would do if we allowed them to allocate the right to trade on inside information. It’s likely, though, that some firms would figure out ways to reallocate property rights to enhance shareholder value. I say we take Winans’ advice, reconceive of insider trading as a property rights issue, and see what the market produces.

Last Friday was the first day of my Business Organizations class. We began with two articles that have profoundly influenced my thinking about the world in general and the business world in particular. To inaugurate the new semester, I thought I’d take a moment and pay tribute to the insights in those articles (and solicit first day ideas from other business law profs!).

The first piece is F.A. Hayek’s The Use of Knowledge in Society. The article, written at a time when socialism was all the rage among the intelligentsia, pointed out the fundamental flaw in the socialist system. The problem Hayek highlighted was not the much-discussed motivational problem (i.e., why create wealth when the government is going to take it from you and give it to someone else?) but was instead an informational problem: how can economic planners allocate resources to their highest and best uses, and thereby maximize wealth, when the planners are not privy to the time- and space-specific information that determines what those uses are? In Hayek’s words:

The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate “given” resources — if “given” is taken to mean given to a single mind which deliberately solves the problem set by these “data.” It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality.

The solution to this problem, Hayek argued, is the price mechanism, which he dubbed a “marvel.” Indeed it is. Market prices incorporate gobs of information and quickly process it to produce a single metric that tells consumers and producers precisely what they need to know: whether they should increase their production/consumption or cut back on it.

Suppose, for example, that you own an oil well and can select the level at which you produce oil. You pick up the morning newspaper and read four headlines: (1) “Unrest Worsens in the Middle East”; (2) “Huge Oil Reserve Discovered Off Coast of New Jersey”; (3) “New Senate Leadership Refuses to Budge on ANWR Drilling”; and (4) “GM Announces Plans to Switch Production from SUVs to Hybrids.” What should you do??? Well, headlines (1) and (3) would suggest that oil supplies are going to be tightening, so you should increase production; headlines (2) and (4) suggest just the opposite. What you really need to know is the expected magnitude of each of these effects (and all the others related to oil supply and demand). Fortunately for you, though, you need not spend all day scouring the newswires for oil-related information and estimating the significance of each datum. All you need to do is look at the price of oil, which tells you the best guess of millions of folks about whether or not we need more oil. This is utterly amazing. In Hayek’s words:

The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned. … The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; that is, they move in the right direction. … I have deliberately used the word “marvel” to shock the reader out of the complacency with which we often take the working of this mechanism for granted. I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind.

The bottom line for Hayek, then, is that resources are most efficiently allocated not by centralized planners but by the “man on the spot” responding to the information inherent in market prices.

Enter Professor Coase. In The Nature of the Firm, he observed that this is absolutely not what we see in business organizations: “Outside the firm, price movements direct production, which is coordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur/coordinator, who directs production.” Thus, “the distinguishing mark of the firm is the supersession of the price mechanism.” Business organizations are, in short, little islands of socialism in which Hayek’s beloved price mechanism is “superseded.”

So why do these “islands of conscious power” emerge? Because there are costs to using the market to allocate resources — most notably, transactions costs. Suppose, for example, that you want to start a catering business. You could minimize your labor costs by going down to the unemployment office every day and hiring, for the day, the laborers you’d need to fill that day’s orders. By taking that tack, you could pay the lowest wages possible (since your workers’ next best option would be unemployment), and you could ensure that you didn’t have any idle laborers (since you could hire only as many folks as you’d need to fill that day’s orders). But of course you wouldn’t do that because it would be extremely costly to engage in this process day after day. Instead, you’d hire some folks for the long term, accepting the possibility that you’ll probably have some periods of employee idleness. Business organizations emerge, then, as means of economizing on transactions costs. They will grow until the degree to which they reduce transactions costs is exceeded by the efficiency losses they create (e.g., the costs of idle resources, the agency costs that inevitably result when managers command resources they do not own).

This conception of the firm as a construction designed to minimize costs has profound implications for the law of business organizations. It also shows us how transactional lawyers can create wealth (as opposed to merely redistributing it, as lawyers often do). If the nature of the firm is as Coase describes, then the law should treat business organizations as no more than cost-minimizing nexuses of contracts between the suppliers of capital, managerial talent, and labor. This suggests (1) that the law should provide some “off-the-rack” nexuses of contracts that would appear to reflect the needs of large classes of business entities, and (2) that these various off-the-rack collections of contracts should be freely tailorable by business planners. Transactional lawyers can add value, then, by tailoring these off-the-rack contracts to meet their clients’ specific needs.

[Interestingly, Henry Manne has recently suggested that business planners might want to create Hayekian price mechanisms within the firm in order to enhance the quality of information available to managers. His fascinating short paper Hayek, Virtual Markets, and the Dog that Did Not Bark suggests how planners might choose to authorize insider trading (or internal prediction markets) in order to provide managers with the information-revealing benefit of prices.]

That’s the nutshell version of the first day of my Bus Orgs class. I’d be most interested in hearing what other law profs do to introduce this subject.

Today’s WSJ has a great article by Holman Jenkins on reporting on the backdating “scandal.”  Larry is, of course, on the case.  I would also — modestly — point out that much of what Jenkins says in his article today, I said in this space about four months ago, when the news was first breaking.  The key elements:

1. The notion that backdating gives executives an incentive-defeating ”paper profit right from the start” is asinine.
2. “Backdating” may make perfect sense as a means of compensation, especially given certain regulatory quirks.
3. If the practice amounts to corporate shenanigans, they sure didn’t bother to hide it very well.
4. Non disclosure of the practice, if disclosure was required, may, of course, be illegal.
5. To quote Larry, ”second-guessing executive compensation is a tricky business, even when the problems seem clear.”

On the somewhat-related matter of spring-loaded options (the raising of which was not at all inappropriate, Elizabeth), I find myself in complete agreement with Larry.  Strange, I know.  But it ain’t misappropriation if the board knows what’s going on.  Once again, perhaps some disclosure is required, but it’s hard to see how non-disclosure of the compensation scheme could transform informed executive compensation into a section 10(b) violation.

In both cases, I’m pretty sure there’s no “there” there, but I’m equally sure we’ll be reading (and litigating) about them for quite some time to come.

Over at Professor Bainbridge’s place, Iman Anabtawi has some thoughts on the granting of “spring-loaded” options, an option granted at a market price that does not incorporate some favorable non-public information, and insider trading laws. The practice is analytically similar to granting a discount option (one with an exercise price below the market price) and is related to backdating (issued retroactively after the information is released). Check it out.

UPDATE: Ribstein responds.

Greetings loyal fans (i.e., “hi mom”) (actually, I’ve made this gag before, and so I think it’s time to set the record straight:   My mom has almost certainly — nay, certainly — never, ever read this blog.  I’m pretty sure she has no idea what a blog is at all.  She may not even be sure what a computer is.).

Apologies for my prolonged absence — I’ve been swamped with moving, new job, selling/buying houses, a sick baby, the flu and grading exams.  

Which also means I’m a little late to the party with this comment, but here goes: 

A week or so ago, my dad had an op-ed in the WSJ, mentioned by several bloggers, including Josh and Thom.  Steve Bainbridge also commented on the article.  As his comments turned to his thoughts on insider trading in prediction markets, Steve wrote this:

On the other hand, in commercial prediction markets like TradeSports contracts, the proprietor of the market presumably has an incentive to eliminate informed insider trading. If there’s a fairly high probability that you’d be betting against somebody with inside information, who thus can’t lose, would you bet? Me neither. At a Vegas craps table, gamblers expect to be protected from the house using loaded dice, but insider trading amounts to the use of loaded dice by the insider because of his informational advantage. Assuming a commercial prediction market makes money by taking a rake out of every wager, it is in that market’s interest to maximize the number of bets placed.

It’s an argument he’s proffered before, but I just don’t get it.

I just don’t think the conclusion about the unattractiveness of “rigged” commercial markets holds, at least not across the board.  In the stock market, when it comes to uninformed, diversified investors for whom every investment in every stock is effectively a 50-50 proposition, the presence of insider trading should not matter.  Why would these people care one bit whether there were insiders trading in the market?  Each also has a 50-50 chance of benefitting from the insider trading (as from being harmed), but if insider trading also increases returns across the market, they will surely prefer the “rigged” market.

As to the commercial prediction markets, the question, “If there’s a fairly high probability that you’d be betting against somebody with inside information, who thus can’t lose, would you bet?” and the analogy to a casino are really not appropriate here:  First, who says the probability of betting against a perfectly-informed insider is “fairly high?”  Insiders aren’t binary; it’s not the perfectly informed betting against the ignorant.  A market that permits insiders to trade permits not only the perfectly informed, but also the less-than-perfectly-informed, the mistaken, the over-confident, and the stgupid to trade, as well.  It is simply not the case that particpating in a prediction market that permits insider trading is a losing proposition for everyone but the insiders.

Second, you’re not betting against the house and its loaded dice in the market.  Unlike at the craps table where odds and payoffs are fixed, market prices fluctuate, in part taking account of the likelihood indsiders are trading (hence many people’s arguments in favor of opt-in, disclosed insider trading).  What’s more, you are almost as likely to be betting with the “loaded dice” as against them in the market, and the thumb on the scale (to mix metaphors) is as likely to help as it is to hurt.  (And, to return to stock markets again, for the diversified investor the “thumb on the scale is more likely to help:  Those who buy and hold are never on “the other side” of an insider transaction after the initial buy-in, and, again, if insider informed trading improves overall efficiency, the buy-and-holders should be net beneficiaries.)

So I just don’t get the aversion to insider trading in prediction (or any other) markets.  But perhaps that’s just a function of my genes — what am I missing?

As Josh noted, Henry Manne recently published a WSJ op-ed arguing for liberalization of insider trading on efficiency grounds — chiefly, because such trading “aids capital allocation decisions and informs business executives through market-price feedback of the best predictions about the value of new plans.” (For a more complete statement of Henry’s argument, see here.)

Today’s WSJ includes several letters in response, including one by Kenneth Kehl, who accuses Henry of “emphasiz[ing] efficiency at the expense of fair play.” I hear versions of this “I Don’t Care If It’s Efficient, It’s Just Not Fair” argument all the time. They’re generally unpersuasive, for if insider trading were legal, any investor who bought stock of a company that had not privately (i.e., contractually) banned such trading would know what she was getting herself into and would be compensated (via a price adjustment) for the risk associated with such trading.

Kehl’s argument, though, is not actually a fairness argument; he’s really concerned with efficiency. (more…)

When Henry Manne writes about insider trading, as he does this week in the WSJ op-ed, one can be sure that it is worth reading. The op-ed, which is the first installment of a two part series, offers two central points: (1) the behavioral finance literature does not support the regulation of insider trading, but has pushed usefully pushed economists to think beyond the realm of the “marginal trader” and into a Hayekian theory of price formation, and (2) this “wisdom of crowds” approach to price formation provides a new rationale insider trading regulations. The key paragraph:

“Since such trading clearly makes the market process work more efficiently, it aids capital allocation decisions and informs business executives through market-price feedback of the best predictions about the value of new plans… .
The new approach would suggest that it is undesirable to have laws discouraging stock trading by anyone who has any knowledge relevant to the valuation of a security. Thus, assembly-line workers, administrative assistants, office boys, accountants, lawyers, salespeople, competitors, financial analysts and, of course, corporate executives (government officials are another story) should all be encouraged to buy or sell stocks based on any new information they might have. Only those privately enjoined by contract or other legal duty from trading should be excluded. The “wisdom of crowds” can do far more for the welfare of American investors than all the mandated disclosures and insider trading laws that the SEC and Congress can think up.”

Henry makes a more detailed version of this argument in this paper. Here are some early reactions from Larry Ribstein and Tyler Cowen. One particularly interesting feature of this rationale for insider trading is the fascinating issues it raises with respect to the adoption of corporate prediction markets as the basis for firm decision-making and resource allocation. If one believes that information markets can improve firm decision-making and corporate governance, insider trading laws are a substantial barrier to achieving those efficiencies.

As Lisa Fairfax notes over at the Glom (see here), Martha Stewart has decided to fight the civil insider trading charges filed against her by the SEC in June 2003 (more here). The complaint had been stayed pending resolution of the related criminal proceedings. With those proceedings resolved, the SEC lifted the stay last month. The complaint also named Stewart’s Merrill Lynch broker, Peter Baconovic, as a defendant. While from Stewart’s perspective there is not a lot of money at stake (the SEC alleges she avoided losses of $45,673 by engaging in insider trading), in addition to disgorgement of losses avoided and civil penalties, the complaint seeks an order barring Stewart from “acting as a director of, and limiting her activities as an officer of,� any public company.

The SEC is trying to nail Stewart as a tippee under the misappropriation theory of insider trading. Under this theory, the SEC has to prove, among other things, that: (more…)

Today’s WSJ reports that professional stock analysts employed by brokerage firms are up to their old sunny ways. These “sell-side� analysts came under fire in 2002 for rendering falsely optimistic trading recommendations. Congressional hearings revealed that during the late 1990s, analysts’ “buy� recommendations outnumbered “sell� recommendations by nearly 100 to one.

Well, according to today’s Journal, “The froth is back�:

After the brokerage scandals involving biased analyst recommendations in the 1990s, Wall Street was supposed to start warning more often about stocks that could fall, rather than just giving upbeat views. But Mike Mayo, who covers bank and brokerage stocks at Prudential Financial Inc.’s Prudential Equity Group, thinks the research reforms of 2003 haven’t fundamentally changed Wall Street’s bullish bias.

In an article prepared for the May-June issue of CFA magazine, Mr. Mayo notes that Wall Street analysts have 193 “buy� recommendations on the 10 U.S. stocks with the largest market values. And how many sells? Just six.

I suppose this 193-to-six ratio is a bit of an improvement. It’s also possible that analysts genuinely hold these bullish beliefs about the stocks at issue. But that does seem pretty improbable. More likely, analysts are once again responding to pressures from their firms’ much more lucrative investment banking operations, which don’t want pessimistic (realistic?) recommendations that might put off actual or potential clients. Prudential’s Mr. Mayo has an alternative theory. He says this “systematic bias� toward optimism is the result of “the threat from covered companies to punish analysts with negative opinions by shutting off their access to management.�

Regardless of the source of their optimism, sell-side analysts appear to be less inclined to report equity overvaluation than undervaluation. Same goes for the managers of mispriced firms, who will generally take price-correcting action when they believe their stock to be undervalued, but not when they perceive it to be overvalued.

These facts have implications for insider trading policy: They suggest that insider trading that tends to drive inflated stock prices downward toward actual value is more beneficial in terms of stock market efficiency than insider trading that tends to drive stock prices upward. For more on this, see my forthcoming law review article Overvalued Equity and the Case for an Asymmetric Insider Trading Regime. (Discussed here.)

Today’s W$J reports on an odd lawsuit the Australian government is pursuing against Citigroup. According to the Australian Securities and Investments Commission, a smoke break conversation between Citigroup employees resulted in illegal insider trading. Citigroup, it seems, was representing bidder Toll Holdings, Inc. in a yet-to-be-announced hostile bid for Patrick Corp., Austrialia’s largest port cargo handler. Someone from Citigroup’s investment banking operation allegedly shared information about the deal with one of Citigroup’s proprietary traders (i.e., someone who trades securities for Citigroup’s own account). The trading that followed, Australian regulators say, violated the law.

This seems pretty straightforward. Indeed, the regulators’ lawsuit would make perfect sense if the I-banker had informed the trader of the forthcoming bid, and the trader had then purchased stock of the target. But that’s not what happened. Instead, here’s what occurred:

The morning of the conversation at issue, the Sydney Morning Herald reported that a takeover bid for Patrick appeared imminent. The report prompted the Citigroup trader to begin purchasing Patrick stock for Citigroup’s account. At about lunchtime, a Citigroup I-banker learned of these purchases. He then contacted the proprietary trader’s boss and said, “Do you know who is buying Patrick shares?” and “We may have a problem with that.” Inferring that Citigroup must be representing the bidder, the boss then took the trader out for a 3:30 p.m. smoke break and told him, without giving a reason, to stop buying Patrick stock. (Such purchases, after all, could drive up the price of Patrick stock, creating problems for the bidder, Citigroup’s client.) The trader then began selling the Patrick shares before the market closed at 4:00 p.m.

That’s it. According to the Journal, “the trading [the proprietary trader] did prior to the smoke break isn’t in question, because only after that conversation with [his boss] was [the trader] considered privy to insider information.”

On the basis of these alleged facts, the Australian regulators are seeking fines, compensation for the bidder, and an order requiring Citigroup to declare publicly that it violated the insider trading laws.

Now, I know not one iota about Australian insider trading law (although it’s got to be more coherent than our screwy doctrine). I can’t see, though, how the “insider trading” at issue could possibly have injured either Citigroup’s client or the trader’s trading partners. Citigroup’s client, the bidder, could only have been helped by the post-smoke break sales (if they had any price effect at all, it would have been to lower Patrick’s price). The folks who bought the stock from Citigroup probably got it at a price lower than they otherwise would’ve had to pay. With the informed sales, Citigroup basically acted contrary to its own interest in order to benefit its client, the bidder. The investors who purchased from Citigroup were lucky beneficiaries of this loyalty. And Citigroup is to be punished?

Our own securities regulators have taken every opportunity to expand insider trading liability. I thought, though, that this was a distinctly American phenomenon. Guess I was wrong.