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Insider Trading Isn’t So Simple

Insider Trading Isn’t So Simple

Thursday, 18 October, 2018 - 07:15
Insider trading.

I have quoted it before, but the Justice Department’s brief asking the Supreme Court to review the Newman insider trading decision is really one of the most interesting documents in insider trading law. Here is how it describes the work of stock analysts:

Effective professional analysis of the value of a company’s stock is a labor-intensive process that demands extensive research, an understanding of financial and other technical data, in-depth knowledge of the relevant industry, and sophisticated modeling. If certain analysts sidestep that labor by siphoning secret information from insiders in breach of their duties, thereby arriving at “predictions” of corporate performance that no model can equal, then other analysts will be discouraged from doing the work that is necessary for the markets to function effectively.

The model of investment analysis here is one of book learning and arithmetic: You read a lot of public information about companies and industries and stuff, then you build a spreadsheet to do some really good math on a company’s public financial statements, and then you have a view of value that is better than everyone else’s. This is, of course, an extremely popular model of investment analysis, among amateur investors and professionals and also robots. And it does tend to make markets more efficient, prices more informed: Reading a company’s public disclosures all the way through, and doing good arithmetic to them, is not trivial, and the work of doing it is socially valuable.

But it is not the only model. A lot of securities analysis is conducted by telephone. Analysts develop hunches about what is behind the numbers in the published reports, and then call up the company to ask about them. They meet with corporate executives or investment-relations professionals one-on-one or at conferences. They talk to corporate executives to propose transactions or stock buybacks or management changes, and listen to the executives’ responses. They talk to experts in the field, some of whom might have experience with the company’s products. They talk to patent lawyers about its patents, geologists about its oil reserves, information security researchers about its data practices. They talk to the company’s suppliers to see how many supplies it is buying, and to its retailers to see how many units it is shipping. They call up lobbyists to get insight on how Congress and the agencies will regulate the company. They find former employees on LinkedIn and ask them about the company’s morale, and if it’s doing any fraud. They commission proprietary surveys of consumers, or pay pollsters for early access to their surveys. They fly helicopters over the company’s oil tanks, or pay satellite companies for images of its parking lots. The techniques of gathering information are infinite, and they tend to focus on getting information that other people don’t have.

Are all of these things fair? I don’t know what “fair” means. Are all of them legal? In insider trading, famously, nobody quite knows what “legal” means. There is no statute defining or prohibiting insider trading, and the Securities and Exchange Commission rules on it are slim. But there are some judicially created rules that more or less make sense, that focus, roughly speaking, on whether insiders are using someone else’s information for their own gain. (A question that has nothing to do with market fairness, by the way.) But those rules are hazy and much disputed, and they aren’t written down in one place.

So it was nice that last week Preet Bharara, the former US attorney who prosecuted the Newman case, and Robert Jackson, an SEC commissioner, proposed a new panel to figure out what insider trading law should be and write it down:

The law can be updated and made clearer. Ideally, Congress would take the lead. But bipartisan proposals to update the law have languished for years. The S.E.C., however, does have the authority to clarify insider trading law. The commission should use that authority before the next wave of corporate abuses.

That’s why we are announcing the creation of the Bharara Task Force on Insider Trading, a panel of experts that will propose new insider trading reforms to protect American investors.

In principle this is a good thing: If insider trading is a crime, there should be a law that says that it’s a crime, and that defines what it is. Then everyone can know what is legal and what isn’t. Good.

On Friday, the task force sent out an email announcement of its list of members. 1) Of the eight names, five are former federal prosecutors (four in the Southern District of New York) and one is a former SEC enforcement lawyer. The other two are law professors. None are securities analysts, or hedge-fund managers, or mutual-fund managers, or corporate lawyers, or public-company chief financial officers. None are users of the capital markets. 2) None are investors whose job is talking to companies, or corporate executives whose job is talking to investors, or short sellers whose job is discovering fraud, or activists whose job is to influence corporate actions, or compliance lawyers whose job is figuring out what sorts of conversations are allowed.

This strikes me as a strange way to figure out insider trading. It seems to me that insider trading law is primarily about the design and structure of the capital markets: How are people supposed to get information? When can companies talk to their shareholders and what can they say? What research methods add to the market’s efficiency, and what methods undermine confidence in the markets? If those are the questions you are interested in, it seems weird to answer them with a committee of prosecutors. You might want one prosecutor on the committee, for practical advice about how investigations and trials work. But most of the committee should spend its time thinking about capital markets, not about criminal litigation.

The alternative view is that insider trading law is primarily about punishing crime, that talking to companies is as straightforward and clear-cut a crime as, you know, murder, and that the important thing is to write it down in a way that makes it as easy as possible to put people in prison for it. If that’s your goal then you want a lot of prosecutors to make sure you’ve covered all the ways people might get out of prison, and no one else—because what else is there to think about?

I don’t want to exaggerate these differences. Most insider trading cases do look mostly like straightforward crimes! When a corporate chief executive officer tips his golf buddy about an upcoming merger, that probably doesn’t add much to society’s stock of knowledge about the world; it seems like the sort of straightforward corruption that ought to be punished whether or not the golf buddy hands the CEO a sack of cash in exchange for the tip. You can see why a committee of prosecutors would want to streamline the prosecution of cases like that.

But most of the controversy in insider trading law is not about those straightforward cases. Instead it is about the boundaries of legitimate research, about expert networks and political intelligence and corporate investor relations. The Newman case was not about a CEO tipping his golf buddy off about a merger. It was a case of hedge-fund managers who, as part of their “extensive research” and “in-depth knowledge of the relevant industry,” talked to people who talked to people who talked to an investor-relations employee of a public company who gave out some information about margins that prosecutors thought was too good. The questions there—How can analysts interact with the companies they own? What information is too good to trade on? What sorts of research are off-limits? When are investors responsible for the misconduct of their sources?—are hard, and they really are questions of capital-markets design rather than prosecutorial tactics. If there was an obvious consensus on what should be illegal, then it would make sense to get together a team of prosecutors to figure out how to punish it. But I’m not sure that’s the case.


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