Current insider trading law is a theoretical mess. Legal experts have described it as seriously flawed, ill-defined, inconsistent, dysfunctional, and an enigma. A recent paper posits a new theory of insider trading which may provide some coherence what is now a dog’s breakfast. For those in investment research, any improved clarity would be a godsend.
Sung Hui Kim, a law professor at UCLA, released a paper last month titled “Insider Trading as Private Corruption” which argues that insider trading should be based on a corruption standard rather than the current standard of common law fraud. Kim posits a new definition of insider trading: “use of an entrusted position for self-regarding gain.” In her view, insider trading is a form of private corruption, analogous to public corruption.
In the paper, Kim applies the new standard to existing insider trading cases, including controversial cases which exemplify regulatory overreach. In SEC v. Dorozhko, for example, the SEC argued that a hacker’s infiltration of a company’s server and his subsequent trading on the extracted financial information violated federal insider trading law. However, based on precedent, the hacker would not be liable for insider trading because insider trading generally requires the breach of a fiduciary duty. Nevertheless, the Second Circuit Court of Appeals held that liability could be found—even without a breach of fiduciary duty—as long as the defendant “affirmatively misrepresented himself in order to gain access to material, nonpublic information, which he then used to trade.”
In Kim’s view the SEC has benefited from confusion and disagreement, as it has attempted to expand the scope of liability. As we have noted, recent insider trading cases have assaulted mosaic theory, the main protection for security analysts performing primary investment analysis.
Regulatory hubris and confusion in the courts has led some legal scholars to question whether insider trading regulation is necessary at all. Skepticism is grounded in the claim that insider trading directly harms no one since it is difficult to even identify a specific victim of insider trading. Critics also argue that insider trading improves market efficiency by moving security prices towards the price that the security would command if the inside information were publicly disclosed.
The ban on outsider trading (those that are not insiders but have “misappropriated” inside information) has been criticized even more. Under the misappropriation theory, the test is whether the defendant has breached a fiduciary-like duty owed to the source of information by trading on that information—regardless of whether the source is the issuer of the traded securities or is even a market participant, making the reach of the misappropriation theory very broad.
Worse, it isn’t entirely clear who falls within its grasp. Courts have failed to provide any concrete guidance on how to identify a fiduciary or fiduciary-like relationship, a notoriously fuzzy concept. The breadth and vagueness of the misappropriation theory disturbs legal scholars (as well as security analysts).
Kim’s approach is to view insider trading as a form of corruption. As such, it imposes three penalties on governance and markets: temptation, distraction, and legitimacy costs. Temptation costs distort decision making for private gain. For example, a corrupt corporate manager might accelerate receipt of revenue, change depreciation strategy, or alter dividend payments in an attempt to affect share prices and insider returns. Distraction costs misallocate time and attention. Legitimacy costs undermine confidence in markets.
Kim applies her theory to some of the controversial recent cases. In SEC v. Dorozhko, the hacker would not be liable for insider trading under Kim’s theory, although he would be liable for hacking under other laws. Although the hacker’s gain was self-regarding, he did not use any entrusted position to obtain it. His actions were criminal but not “corrupt.” Further, in Kim’s view, the hacker’s conduct, is unlikely to be perceived as systemic in a way that might raise serious legitimacy costs to the securities markets.
She also examines SEC v Mark Cuban and concludes that Cuban would not liable for insider trading under a standard of private corruption. Although his gain could be classified as self-regarding, he did not make use of any entrusted position to obtain it.
Security analysts, whether on the sell side or the buy side, have been chilled by recent insider trading cases which seem to cast doubt on the mosaic theory safe harbor. Alpha is the reward for insights which are non-public, that is, before the views are generally incorporated in the market. In principle, analysts should be rewarded for doing a diligent job researching a public security, and in the process uncovering non-mainstream insights. In practice, primary research has become much more risky and there is now less of it being performed. This has a negative impact on security markets.
Kim’s theory is an interesting one and if it becomes an accepted standard would help to clarify the current insider trading mess. But would it help security analysts? The focus on an “entrusted position” might provide some clarity, but is that really an improvement over “fiduciary duty”? If the analyst was given information in confidence by corporate insiders then they have been entrusted, but that isn’t the part of the job that is murky. Does a channel check make one entrusted? What if you speak to low level company employees as part of your channel check, would that make you entrusted? Unfortunately, the pragmatics of any new theory would need to be tested, and for now, caution remains the rule.