Laws Against 'Insider' Trading Come With a Great Cost

Several weeks ago, a federal court reminded the Department of Justice that trading on nonpublic information is not necessarily a crime. "Although the Government might like the law to be different, nothing in the law requires a symmetry of information in the nation's securities markets," wrote the United States Court of Appeals for the Second Circuit in an opinion overturning two insider trading convictions. The opinion was a much-needed reminder that, in many circumstances, it is perfectly lawful for people to trade on information that others do not have. Allowing such trading is also good for the markets.

Insider trading is largely a judicial construct built on a broad anti-fraud provision in the securities laws. There is no statutory definition of insider trading. In the past, Congress has toyed with defining insider trading precisely, but instead left the concept open-ended to afford government attorneys more leeway in fashioning cases to fit new fact patterns. The Department of Justice, which has authority to bring criminal insider trading cases, and the Securities and Exchange Commission, which has civil insider trading authority, have stretched the concept of insider trading to cover more circumstances over time.

At issue in this case were trades in two companies' stocks based on information from company insiders. In both instances, the traders received the information indirectly. With respect to one stock, the company insider provided nonpublic information to a friend, who provided information to someone else, who in turn provided information to a group of analysts, who provided it to the defendants in the case. (When that many people outside the company have information, it starts to look a lot less nonpublic.) Rather than focusing on the leakers or the people to whom they leaked, the government focused on traders far down the pipeline who may have had no inkling about the original source of information or the impropriety of the leak.

In pursuing traders far outside the leaking insider's circle, the government has used what the court characterizes as "doctrinal novelty." Here, the government argued that the end-of-the-chain traders should have known that there was a crime committed at the beginning of the chain-that confidential information was leaked in breach of a fiduciary duty and in exchange for a meaningful benefit to the leaker. But the government was not able to show that there was a benefit, let alone that the traders being charged were aware of the benefit. Consequently, the government's insider trading case collapsed.

SEC Chair Mary Jo White reportedly criticized the decision as "overly narrow," but unlawful insider trading should be narrowly construed because insider trading is not all bad. As former George Mason University School of Law Dean Henry Manne has pointed out, "[t]here is almost no disagreement that insider trading does always push the price of a stock in the correct direction." Making stock prices more accurate is a good thing. As Manne explains, it can even be good for the company being traded. An overly broad conception of what constitutes insider trading, therefore, can be harmful.

Yet the trend seems to be toward a very broad conception of insider trading that would prevent traders from using their unique informational advantages in the marketplace. For example, in December, Senators Carl Levin and John McCain introduced a bill-"the Ending Insider Trading in Commodities Act"- that would prevent large financial institutions from trading in commodities, futures, and swaps "while in possession of material, nonpublic information related to the storage, shipment, or use of the commodity" obtained from the large financial institution's involvement in the commodities business. Almost any trade by a large financial institution that owns or finances any company involved in storing, transporting, or using commodities potentially could constitute illegal insider trading under the bill's construct. This bill is one example of an attempt to prevent traders with knowledge gained through legitimate means from acting on that knowledge.

Depriving the markets of its most informed traders harms market quality. The stock market would look a lot like a lottery if traders possessing nonpublic information had to wait for every other trader in the market to acquire the same information before trading.

Outlawing broad swaths of trading by people with informational advantages may have rhetorical appeal, but it also comes at a cost. An insider trading enforcement policy that goes beyond pursuing traders who have obtained material, nonpublic information through theft or deception runs the risk of unnecessarily depriving markets of critical information.