by Professor David Phillips
Criminal prosecutions brought by the Justice Department and civil actions instituted by the Securities and Exchange Commission against parties accused of “insider trading” have been prominent in the news lately. SAC Capital Advisers LP, a hedge fund, in a settlement of a criminal prosecution by the United District Attorney for the Southern District of Manhattan, has agreed to pay a penalty of $1.8 billion. That criminal penalty is in addition to an earlier settlement with the SEC involving a civil penalty of $616 million. These actions follow an earlier criminal prosecution involving another prominent hedge fund, Galleon, and its founder, Raj Rajaratnam, also for insider trading.
What exactly is “insider trading” and why is it illegal? In fact, the term, “insider trading,” has never been exactly defined. Clearly it includes a corporate officer or director trading the stock of his/her own corporation on the basis of information that has not yet been publicly disclosed and that would be important to most investors in deciding whether to buy or sell that stock. At the other end of the spectrum, an investor who does independent research based on publicly available sources and buys or sells a corporation’s stock would not be guilty of “insider trading” even if the party at the other end of the trade is unaware of the same information. There’s a wide range of conduct between these two examples, where accused parties have or have not been found to have engaged in illegal conduct. Interestingly, about 30 years ago or so the question of whether insider trading should be illegal was hotly debated, and occasionally one still finds writings that argue against penalizing the practice.
Like many, if not most, legal issues, the dividing line between legal and illegal trading on the basis of information that other market participants lack implicates underlying values and policies that sometimes conflict. Public repugnance of insider trading probably flows from an equality norm – all parties in the market place should have equal access to the same information. And the equality norm is itself probably embedded in an ethical norm, common to most ethical traditions, that one should not do to others that which is hateful to you. A person who trades on the basis of information other traders lack would not want, if the positions were reversed, to be on the other side of a trade.
Yet, we also consider the production of information, including information as to the worth of a corporation’s stock, to be a positive good, in the same way that we usually consider the production of necessary physical goods worthwhile. Parties often must invest substantial time, effort and resources in determining whether a corporation’s stock is over or under-valued. An equality norm, which usually translates into a sharing rule (one must disclose the information one has prior to trading), if carried to the extreme, would deter parties from doing so. Allowing parties to trade on information the party has acquired presumably moves the price of the stock that party buys or sells towards a more “efficient” price relative to other stocks in the market place. In other words, in addition to the actual trader, other market participants are benefited.
So how do we resolve a possible conflict between an equality norm and a policy of incentivizing the production of information? We’ve chosen to analogize use of information emanating from inside a corporation and not yet publicly disseminated to theft. Use of that information is unlawful. On the other hand, information acquired from exogenous sources or particular conclusions based upon information already released by the corporation and therefore available to all can be used. The claim in the recent insider trading cases is that certain hedge funds used information falling into the first rather than the latter categories.