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In the decades since the SEC decided that trading in your company’s stock could be a form of “fraud” if you were guided by first-hand knowledge public sources couldn’t match, the words “insider trading” have come to sound scandalous. But insider trading has real merits, and it should not be illegal. Raj Rajaratnam, who yesterday began serving an 11-year sentence for it, should be a free man.
As Professor Stephen M. Bainbridge explains , at the end of the 19th century, it was widely understood that insider trading was permissible. It may even have been—in the Supreme Court’s later words—“a normal emolument of corporate office.” But in the early decades of the 20th century, state courts began to find that corporate officers were required to reveal all material information to their stockholders before engaging in stock trades with them. This obligation came from the shareholder-officer relationship in the context of which the trades, which were face-to-face transactions, took place. Only in 1961 did the prohibition of insider trading as we know it arise.
During the New Deal, Congress passed the Securities Exchange Act. In section 10(b), the statute authorized the SEC to issue whatever regulations it deemed “necessary or appropriate in the public interest or for the protection of investors,” and forbade individuals to use “any manipulative or deceptive device or contrivance” that violated those rules. Eight years had passed by the time the SEC issued Rule 10b-5 in 1942, but that rule made no explicit mention of insider trading either; it merely spoke of “fraud” and “misleading” omissions of information.
Only in 1961 did the prohibition of insider trading as we know it arise. That was the year the Securities and Exchange Commission decided that trades committed on a modern stock exchange—in which the buyer and seller don’t directly communicate—could count as insider trading and violate SEC Rule 10b-5.
The core of the prohibition of insider trading is the notion of “material nonpublic information” (MNPI). Information not available to the general public is “material” if there is a substantial likelihood that a reasonable investor would consider it important in making investing decisions about the stock. To count as insider trading, a trader’s purchase or sale of stock has to involve MNPI in the right way—and one of several other factors also has to be present.
Courts have disagreed as to whether MNPI must be the reason for a trade, as opposed to merely being known to the trader at the time, but the SEC has tried to settle the matter with a regulation. Under the rule, that the trader knew the information is ordinarily sufficient, but it’s a defense if the trade was made pursuant to plans, contracts, or instructions that predate his knowledge of the MNPI.
Yet merely trading on MNPI is not sufficient to constitute insider trading. Some additional element is required, concerning one’s relationship to the “issuer” (the company that issued the stock), how one obtained the information, or the market context.
In classical theory insider trading cases, this additional element is a breach of a fiduciary duty the law says is owed to the issuer and its shareholders. Several kinds of insider trader are said to have and breach such duties.
The most familiar sort of insider trader is the classic insider. Classic insiders include, at least, officers and directors of the issuer, and probably some other employees, too. If one is found to be a classic insider, and he trades on MNPI gleaned from his position, that’s insider trading. (Theoretically the legal requirement is to either disclose the MNPI or abstain from trading, but because disclosure is usually impermissible as well, it amounts to a requirement to abstain.)
A second variety is the constructive insider. One becomes a constructive insider by receiving information that the issuer expects him to use only for its purposes and being deemed to have accepted that limitation. Consider, for example, a lawyer employed by a law firm who receives confidential information about a corporation he represents. Even though he is not an employee of the corporation or even in a direct contractual relationship with it, he counts as an insider.
The essence of insider trading is acting on your knowledge of material nonpublic information. And yet acting on your knowledge is exactly what you have to do . . . in order to live.
A third sort of insider, which Rajat Gupta is accused of being, is a tipper, and a fourth, which Raj Rajaratnam was convicted of being, is a tippee. A tipper, who need not actually trade, is someone who, in violation of a duty of loyalty such as those discussed above, passes MNPI to someone else in order to gain some benefit for himself, which may be nothing more than the intangible benefits of giving the recipient a gift. To qualify as a tippee, one must not only have received the information, but have known that the tipper was violating his duty—so it’s possible for the tipper to commit insider trading without the tippee doing so, if the tippee doesn’t realize the tipper could not legally give him the information. According to the government, Gupta committed tipping by telling Rajaratnam information that Gupta had just received as a board member of Goldman Sachs, and Rajaratnam then traded as a tippee by investing in Goldman before the news could be disseminated. Fiduciary duties are imposed on tippees, so a tippee who passes on the information can also be charged with tipping.
The misappropriation theory is a bit different: The trader need not have had any relationship to the issuer; he uses for his own trading MNPI that was entrusted to him in the context of a fiduciary or similar relationship with someone who did not know he was going to use it for trading. Thus, for example, if Dell decided to stop using Intel chips, and a Dell executive therefore sold Intel short before the decision became public, the executive might be committing misappropriation: he had no relationship with Intel, but he owed a fiduciary duty to Dell, and he used information he learned for Dell’s purposes to trade for his own benefit.
A special prohibition on tipping arises in a tender offer: Under Rule 14e-3, insiders of both the would-be buyer and the takeover target are forbidden to tip, whether or not this would breach a duty. Indeed, the bidding corporation’s officers may not tip others to buy the stock even if they think such purchases would help the bidder.
To evaluate the morality of insider trading, we need to begin with basic principles. Human beings live by identifying the facts and acting accordingly. Knowing that fire scares many dangerous animals was valuable to our distant ancestors because it meant that by putting fires in the mouths of their caves, they could keep those animals away while they slept. Knowing the behavior of subatomic particles is valuable because it enables experts to build nuclear power plants from which the rest of us can obtain electricity.
It is not by mere knowledge that we live, but by knowledge that informs action. If one identifies an opportunity but does not act on it, one does not benefit from that knowledge; if one identifies a threat but ignores it, one might as well not have identified the threat at all.
Consider, then, what happened to Mark Cuban, the man behind HDNet and the 2011 NBA champion Dallas Mavericks. According to the SEC, Guy Faure, the CEO of Mamma.com, a tech startup in which Cuban had invested, came to him with a demand: The company was going to sell more stock, which could be expected to reduce the market value of the stock he already held and would make it a smaller percentage of the outstanding stock. If he wanted to preserve his percentage of outstanding stock and the value of his Mamma.com holdings, he would have to fork over more money.
Since he knew that the company was going to do something likely to diminish the value of his stock, and he didn’t think the company was worth investing more money in just to preserve his existing fraction, the rational thing to do (if legal) was to get rid of that investment. That’s what he did.
But according to the SEC, it wasn’t legal: it was insider trading . By confidentially alerting him to the planned stock sale and discussing it with him on the shared premise (which Cuban now argues was mistaken) that it would be illegal for him to sell his existing investment, Mamma.com had established a relationship of trust and confidence that barred Cuban from selling his shares. Under the insider trading laws, as interpreted by the agency primarily responsible for enforcing them, Cuban, having learned of a threat to his investment, was not free to protect himself. He had to act as if he did not know what he knew—even though he had good reason to believe this would be costly.
Notice what role this gives the SEC in the transaction: the role of enforcer for a company that made a demand that—given the insider trading law—bore a distinct resemblance to extortion. Mamma.com threatened to reduce Cuban’s stake in the company and its value unless Cuban forked over more money—and the SEC was prepared to do even greater harm to Cuban if he tried to escape by selling the stock. (Its case against Cuban is now in progress.) Notice also that without the insider trading laws, Mamma.com’s offer to Cuban would have been entirely positive: it would have given Cuban the chance either to expand his holdings or to protect himself from the effects of the company’s plan.
Of course, insider trading laws don’t affect only billionaires. A secretary whose retirement savings is invested in the stock of the corporation for which she works and who learns it will soon declare bankruptcy may be out of a job and a retirement if she doesn’t sell—and in trouble with the law if she does. She may be deemed to have a duty to pretend she doesn’t know what the documents she’s helping prepare say.
It really is a matter of pretend ignorance. Having MNPI is, in general, perfectly legal. Neither Cuban nor my hypothetical secretary did anything illegal in learning that the rational thing to do would be to sell the investment in question. And selling your stock is legal—it can even be legal, according to the SEC, in certain circumstances that indicate that your sale was not caused by your knowledge. The essence of insider trading is acting on your knowledge of material nonpublic information.
And yet acting on your knowledge is exactly what you have to do, as a human being, in order to live.
It’s worth emphasizing that the information is often information that the insider trader has because his employer (or some other party from whom he “misappropriated” it) needs him to have it. The law holds that certain employees violate their duty to their employers if they also act on it in their own interests by buying or selling its stock, even if there is no reason to think their doing so harms the company in any way, and that this violation of duty constitutes insider trading. Information such an employee must know well in order to serve the corporation, he must pretend not to know when deciding about his own investments. He must not act on that knowledge in that context—and yet, if he is to serve his employer effectively, acting on his knowledge is exactly the sort of thing he must make it a practice to do.
Most of the previous examples involve information a trader comes to know without actively pursuing it for the purpose of trading. But much of what people know, they know because they made an effort to learn it. Right now, you’re investing time in reading about the morality of insider trading, and you’re able to do so because you’ve invested in learning English, learning to navigate the Internet, and getting access to the equipment and service necessary to do so. You have not obtained any of this by accident or without cost.
Likewise, if you’re serious about making money in the stock market, you need to pursue information. To begin with, you need to learn at least some of the basics of how the stock market works. You may need to investigate a variety of strategies. Then, depending on what sort of strategy you choose, you may need to investigate various companies or investment professionals.
Knowledge is a value—in Ayn Rand’s words, something “one acts to gain and/or keep.” As a general matter, people do and should seek knowledge and use it. Of course, as with any other value, some prices are too high to pay for it: You should not trick a friend into giving you money, and likewise you should not trick him into giving you information, because your friend’s trust, and your character as someone it is rational for him to trust, are too valuable in the long run to squander. Nor should you try to persuade a friend to divulge information he has agreed to keep secret: that would be bad for his character, and it is good to have friends of good character. An inquiry into the moral character of Raj Rajaratnam, who, according to the prosecutors, paid informants to give him information that was entrusted to them confidentially, would have to consider the nature of his relationships and his effects on his friends’ character, though this neither should be nor (for the most part) is the law’s concern. But as long as you avoid means too costly to be worthwhile, such as the destruction of your own character or that of a valuable friend, obtaining information that can help you make money or obtain other values is a good thing to do.
And obtaining information that is not public does not necessarily involve doing anything counterproductive. For example, especially if there were no insider trading law, you might cultivate a contact who can give you—out of friendship or for payment—information that his company has no reason to keep secret, such as facts it is in the process of releasing. Or you might provide valuable services to a corporation, with part of your incentive for doing so being that you will learn things that can help you trade. Indeed, you might earn important information about a company simply by working for that company.
Even for an investor who intends to stay away from information covered by the insider trading laws, it can make sense to pay experts in an industry for advice on the likely future of that field. But the risk of crossing the line from advice that may legally be sold in that context, to information that may not, is likely to deter people from paying for or providing that expertise—especially now that Preet Bharara, the U.S. attorney for the Southern District of New York, has begun prosecuting people in the expert advice business on insider trading charges. Thus insider trading law not only makes it illegal to trade on certain information; it makes it legally risky to educate traders about your industry.
What information is MNPI is, as noted, sometimes a puzzle, but that’s not the only aspect of insider trading law that’s less clear than might be desired. Here’s another aspect that’s a particularly big problem: it’s unclear which employees are covered by the legal duties that make it illegal for them to trade on the knowledge they gain at work. According to Professor Bainbridge, “Until a majority of the Supreme Court has held that a particular relationship is fiduciary in nature, . . . we cannot know for sure.” He suggests that a geologist who identifies prospective mine sites probably is covered, but a janitor who sees the geologist’s memo while cleaning probably isn’t. Yet even if Bainbridge is right about these two, it’s far from obvious where to draw the line. So a person might think he’s not an insider for purposes of insider trading law, and a court might—after he traded—declare that he was an insider.
From a constitutional perspective, insider trading law represents a particularly egregious case of Congress’s delegating its legislative power. The prohibition of insider trading is neither a statute passed by Congress (although Congress has passed statutes to “enforce” it), nor a matter of common law discovered by the courts. It was the SEC, an unelected body unknown to our Constitution, that created Rule 10b-5, using power granted to it by an act of Congress that did not specify in objective terms what the SEC was to do with it.
Insider trading does not violate the rights of the counterparty—the person who bought the stock from or sold it to the insider trader. (For simplicity’s sake, let’s ignore the brokers and other intermediaries who actually handle trades in large, anonymous markets in publicly traded stocks.)
Although the regulations classify insider trading as a kind of fraud, it isn’t. Fraud is deceiving another person in order to obtain a value from him. But the insider trader, like other traders, does not ordinarily deceive his counterparty—he does not ordinarily tell his counterparty anything at all about the merits of the stock.
In a typical transaction, each party assesses the stock independently of the other; he buys or sells only if he thinks it will be to his advantage to do so, given the offered price and his assessment of the stock’s prospects. Often, this means the transaction reflects a difference in opinion between the buyer and the seller as to the stock’s future: the seller thinks the price will decline, while the buyer expects it to rise.
And this is exactly what happens in a typical insider transaction: The insider and the outsider disagree as to the future of the stock price, so the one with the more pessimistic view sells it to the more optimistic party. Each acts on his own judgment, which is what he should do; neither tries to convince the other of anything.
And the party who did not have the MNPI had no right to it. Knowledge is a value; one has to gain it. One of the notable elements of the Rajaratnam case is the scope of the network Rajaratnam and his colleagues assembled in order to gather information on which to trade.
To know something, one must learn it: A process of learning on one’s own part is required even when one is being taught by another person. A human being cannot, as in the grade-school fantasy, simply absorb knowledge from a pill. If he is to have knowledge, he must examine the facts, directly or as presented by another, and come to understand them. A right to knowledge, then, can only be either a right to pursue knowledge or a right to have information made available.
But because knowledge is a value one must make an effort to obtain, a right to have others make their knowledge available would be a claim on their effort—and a bigger claim the more they learned. It would be a demand that each of us serve everyone else—and, because we would have to offer up all our knowledge, it would doubly diminish the rewards of pursuing knowledge: not only would anything one learned create a duty to spend one’s time and energy passing that information on to anyone who wanted it, but having gained the knowledge would not give one opportunities others did not have—and therefore, in many cases, would not give one opportunities at all.
Thus there can be no right (except as a contractual matter) to be told what other private individuals have learned. There is only a right to seek knowledge—a right with which insider trading does not interfere, but which insider trading law burdens, by in some circumstances attaching to knowledge a restriction on one’s right to trade.
There is one ethical concern about insider trading that should be noted, although it is not a ground for criticism of all insider trading and does not justify prohibiting any. Even though insider trading isn’t a violation of anyone’s rights, it raises questions of honesty. One should not seek to gain values by relying on others’ failure to recognize the nature of one’s actions, for then one must seek out the imperceptive, who are poor sources of value—and one must fear the intelligence and rationality of others, and therefore avoid the very people one should seek to know. While one does not seek out individual counterparties for one’s trades in an anonymous market, the insider trader gives himself a reason to fear its being discovered, and thus becoming widely known, that he is trading on MNPI.
If a potential counterparty knew the inside information, he would presumably not make the trade at the same price. Indeed, if he knew that one was relying on information he didn’t have, it might make him reluctant to make the deal: if one is selling on MNPI, that strongly suggests that the information provides a reason to sell and not buy, and vice-versa if one is buying.
Of course, nearly every trader in the market is relying on his own view of what will happen to the stocks he’s trading. Since he believes his view is true, he believes that the contrary view is false—yet he relies on there being someone who holds that view. As with the proverbial horse racing, it is difference of opinion that makes stock trades.
But knowing that another trader is operating on a certain theory will not dissuade a trader who believes that that theory is false. It is possible to release a book explaining one’s theories of the market and still trade, because not everyone will be convinced. A person who trades on a theory others reject relies on their being mistaken, but he can be perfectly open about what he is doing. The insider trader cannot be open and reap the full rewards of insider trading: if everyone in the market knew the nature of his action, he would not get the price he can get by keeping the insider nature of his trade secret.
That said, in some cases, a person with MNPI would buy or sell even if others did know the nature of his trade; he might not make as much profit or avoid as much loss, because the known fact of his insider trading would come to affect the price of the stock involved, but in most cases he would be able to get some price. If he would be willing to make the deal at the price he would get if he acted openly, and especially if the instructions he gives his broker are such that the trade would go through even if the price of the stock changed as the trader thinks it would if the information became public, then while he may benefit from others’ failure to recognize the nature of his action, he is not relying on it. There may be other cases, too, where the insider trader has a moral answer to the accusation of dishonesty. This is a complicated matter worthy of continued ethical reflection and discussion.
Moreover, a person can be open about the fact that he sometimes trades on inside information. So long as a fairly small portion of his trading activity is based on inside information, the mere fact that he wants to make a trade will not reveal that he has inside information or what that information indicates about the future of the stock. And the content of the MNPI may be information he would keep secret whether he trades or not.
Even when the insider trader is dishonest, it does not amount to fraud, because he is doing nothing to convince his counterparty of anything. He is not causing the counterparty’s error or even ignorance; he is merely giving himself reason to fear its correction.
So insider trading may sometimes involve dishonesty. But this is of little or no use to the advocate of insider trading law. Not only does it not show that the insider trader violated anyone’s rights or did anyone any harm, it is in tension with the values of insider trading law, which is often concerned with the secrecy of business information. How much, if any, secrecy in business is compatible with the standard of honesty I have discussed is a question for another day.
A supporter of insider trading law may argue that the counterparty is harmed, even if not by having his rights violated. But the counterparty is not harmed by the insider nature of a trade. Suppose I bought 100 shares of X Corp. on July 1 and sold them at a loss a month later. Adam and Bert each sold 100 shares of X Corp. on July 1: Adam on inside information, and Bert because that was when he planned to liquidate his investment in order to pay his son’s tuition. The outcome of the investment for me was not affected by whether the 100 shares I bought happened to be from Adam or from Bert. If I bought from Adam, I did not lose the money because I traded with someone with inside information: Bert’s shares would have brought me the same loss. The real reason I lost the money is simple: I thought the stock would go up, and I was wrong.
It is true that even if the insider trader’s counterparty would have bought anyway, someone is going to end up with 100 more shares because Adam sold his, and Adam has pushed the loss that would have fallen on him onto that person. But even still, no one is harmed by the insider nature of Adam’s trade. Had Adam himself sold the shares for some other reason, the same person would have ended up with them.
To this, the defender of the ban on insider trading may reply: Adam predicted that the owner of his stock was going to suffer a loss. He made sure that loss fell on someone else instead of him. But the same could be said of anyone who sells a stock he predicts will go down; the insider trader may be more certain of his prediction, but both he and the analyst who sells because he thinks the company’s new product is bad are selling a stock in order to make sure losses they expect will land on others, not them.
At this point, the opponent may resort to the notion of “fairness.” If the stock price goes down, someone will take a loss, and it’s not fair—he says—for Adam to get to avoid the loss. “Material non-public information tilts the playing field,” this argument goes. “It gives one person an unfair advantage in the market.”
In fact, many stock traders have advantages. Some have inside information. Others have discovered unusual information from other sources. Still others are better at analyzing a company’s ability to make and sell valuable products, or at predicting the future of a securities market from its recent past.
To be sure, MNPI is an advantage not everyone can get. But different people are able to get different advantages. A socially awkward mathematical genius may be unable to become friends with certain corporate insiders—but a man who is very talented at cultivating friends may be unable to master quantitative trading. Indeed, there are probably more people who aren’t smart enough to be quantitative traders than people who could never obtain inside information, especially when one considers the diverse ways in which such information can be obtained.
The fairness argument is often cast in slightly more specific terms: “Insider trading is unfair to the little guy.” The presupposition here is that the “little guy”—the trader with not much money to invest and no connections to corporate leaders—cannot participate in insider trading, but only the big guys can.
To this, the first response must be to insist that the fact that the “little guy” cannot achieve something is no reason to prevent the “big guy” from doing it. Your highest value is your own life, and you should not limit your potential by chaining yourself to the level of others’ abilities. Besides, consider the ramifications of accepting as a general principle that highly successful people should not be free to do what less successful people are not able to do. Great achievements require great achievers, and if the people who can do things best were not allowed to do them better than the rest of us, there would be no great achievements. And we often benefit from others’ great achievements. Imagine if Google were limited to doing only those things a small company with three programmers and one web server could do!
But the second response is that the little guy can get in on insider trading, in two different ways. First, because there are so many different ways to get inside information that, at some point in a little guy’s life, he may well get some. That’s why little guys, such as secretaries , print shop employees and interns’ boyfriends , are sometimes sued or prosecuted for insider trading. (The print shop worker won in 1980, but he had to go to the Supreme Court, and under modern misappropriation theory he might have lost—the Court found he owed no duty to the company whose documents he was working on, but today he might be found to owe a duty to the print shop, and that would suffice. The intern’s boyfriend’s case is apparently pending.)
Second, because many little guys who participate in the stock market do so by entrusting their investments to professionals, it is not necessary for a little guy to have inside information in order for him to profit from it. Just as a small investor who isn’t smart enough to be a quant can profit from quantitative trading by investing with someone who is, he can profit from insider trading by investing with a firm some of whose trades are based on inside information. (This is made difficult by the insider trading laws, because a firm cannot advertise that it uses such a strategy, but absent such laws it could.)
In fact, it is the insider trading laws that are unfair to the little guy—that is, the investor whose expertise is not in stock investing. To have an excellent analysis of public information calls for a degree of stock-market expertise and a level of investment of time that are out of reach of the typical non-professional. But one can sometimes get MNPI incidentally in the course of one’s work or hobby. In fairness, each investor should be free to use his own informational advantages. But the insider trading laws allow only some informational advantages to be used: the advantages that securities professionals have the biggest advantage in obtaining, because they make it their career.
A final argument against insider trading is that it is costly to a corporation to have its insiders trading on their inside knowledge. Now, maybe this is so, maybe it is not, and maybe it is so in some cases and not so in others.
But where rights are not involved, the proper way to limit your costs in a particular relationship is to set up a contract that protects you. If insider trading were regulated only by contract, corporations could establish the rules that work best for them, considering the costs, if any, likely to result from insider trading in various contexts as well as the benefits of letting insider trading opportunities be a perk of employment.
Perhaps under such a system, insider trading would be prohibited by contract at all corporations. But perhaps not: opportunities to profit from insider trading might be a valuable form of compensation, as Prof. Henry Manne suggests . In any event, even if contracts would prohibit insider trading, that’s no justification for making it a crime: contracts do not carry punishments; a breach of contract merely makes one liable for the resulting damage to the other party.
The idea of loyalty, which insider trading law invokes, does not always support abstaining from insider trading. Trading stock does not always reveal that one has MNPI, let alone the nature of any MNPI one has, so even if one has information it would be improper to reveal, it does not follow that there would be anything wrong with trading on it. Likewise, there is nothing about trading on information one has gained through work that makes it especially likely to be against one’s employer’s interests. So even if it is virtuous to be loyal to one’s employer, being loyal may restrict some trades (and many activities that are not trades), but it does not provide a reason to abstain from insider trading as such.
The notion of loyalty that is at work in insider trading law, which says one must not use information that “belongs” to his employer for his own advantage, is rooted in a vision of employment (or at least of employment in certain capacities) that obliges an employee to utterly suppress his own self-interest while working for someone else. But the point of working for a corporation is to pursue one’s own interest. And while sometimes a person’s long-range interests dictate serving his employer even at a short-term cost to himself (e.g., cancelling a night out in order to complete an important project by morning), this is still ultimately justified by its contribution to one’s own interests—and part of the reason this works is that such commitment actually benefits the employer, who therefore has reason to value it. By contrast, the sort of loyalty the law demands, which requires you to eschew opportunities to make money without regard to how this affects the employer, is not grounded in a benefit to either party. The hard worker’s productive loyalty is motivated by a commitment to producing value for himself and his employer; the suppression of self-interest means a commitment to not producing value for himself.
If the concern is not with the insider trading itself, but with the prospect that insiders might manipulate the stock price to the advantage of their own portfolios, this can be better guarded against by contracts and internal supervision than by laws and prosecutors.
Insider trading, while in one respect morally questionable, is in another respect morally praiseworthy: as a general matter, one should seek knowledge and use it to guide one’s actions. The arguments for banning insider trading, and most of the arguments for morally condemning it, fail. Insider trading ought to be legal.
Likewise, if you’re serious about making money in the stock market, you need to pursue information. To begin with, you need to learn at least some of the basics of how the stock market works. You may need to investigate a variety of strategies. Then, depending on what sort of strategy you choose, you may need to investigate various companies or investment professionals.
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