Academics hotly debate the economic harm of insider trading. A recent paper takes a different approach, focusing on the morality of insider trading. It concludes that most forms of insider trading are morally impermissible, but not in all cases. Further, the paper questions the severity of current insider sentencing and raises the possibility that the current regulatory focus on insider trading prosecution is caused by other concerns than ‘market fairness’.
In ‘Greed, Envy, and the Criminalization of Insider Trading’, John Anderson, a law professor at Mississippi College of Law, reviews current U.S. insider trading law and the economic arguments for and against insider trading. He goes further, however, in examining the morality of insider trading.
U.S. insider trading law, and its blind spots
In the U.S., the Supreme Court has sanctioned only two legal theories under which insider trading breaches a duty to disclose inside information: the “classical” theory and the “misappropriation” theory. The classical theory of insider trading liability focuses on the duty to disclose arising from a relationship of trust and confidence that exists between the actual parties to the securities transaction. Specifically, the classical theory finds liability in circumstances where corporate insiders seek to benefit by trading in shares of their own company based on material non-public information. Such trading breaches the corporate insider’s fiduciary duties to the current or prospective shareholders of the corporation on the other side of the transaction.
The misappropriation theory outlaws trading on the basis of nonpublic information by a corporate ‘outsider’ in breach of a duty owed to the source of the information. However, if the outsider discloses to the source that the outsider plans to trade on any information received, then there is no breach. For example, a law firm engaged by a corporation to work on a pending merger would owe a duty of confidentiality to the company that hired it. However, if the law firm had language in its engagement contract with the company that it intended to trade on any information received from the company, there would be no violation of insider trading law. (It is doubtful that a law firm insisting on such language would have any corporate clients, however.)
As Anderson explains, “Because the deception essential to the misappropriation theory involves feigning fidelity to the source of information, if the fiduciary discloses to the source that he plans to trade on the nonpublic information, there is no ‘deceptive device’ and thus no § 10(b) violation.”
There are other grey areas in current U.S. insider trading regulations. Based on the Supreme Court’s interpretations, there appears to be no insider trading liability where a non-insider acquires material nonpublic information by sheer luck or by eavesdropping on the conversation of insiders. If you overhear a material conversation at Starbucks, you may not be liable if you trade on that information.
Another grey area is when an insider refrains from buying or selling a security that they otherwise would have bought or sold. In such circumstances, there appears to be no Section 10(b) liability because there has been no securities transaction—only an omission. The example Anderson gives is an insider who has a standing order to buy company stock on a recurring basis only to cancel the order on receiving insider information about a pending regulatory action against the company. The insider benefited, but since no transactions occurred, the action is not likely to be liable.
The morality of insider trading
Anderson evaluates insider trading using two moral frameworks, utilitarianism and Kantian moral absolutism. To create a level moral playing field, he also assumes that there are no existing laws prohibiting insider trading.
The key utilitarian principle is that “the right act for an agent to perform in any situation is that act, of all those available to her, which will bring about the greatest net satisfaction for society as a whole.” Using utilitarian principles, Anderson finds the following harms in insider trading: 1) the undermining of companies’ ability to prevent insiders from trading where such trading is harmful to their interests (e.g., in merger negotiation scenarios), (2) injury to the practice of promise-making in general, and (3) potential increase in the cost of capital for companies resulting from the anticipated increase in the bid-ask spread.
The counterbalancing benefits are the benefits to the inside trader and the potential for increased market accuracy. Anderson concludes that, on balance, insider trading is harmful under utilitarian principles.
However, if no promises were made (and assuming there are no existing laws prohibiting insider trading) the outcome would be different. If, for example, there were no general prohibitions against insider trading and a company were indifferent or condoned insider trading, then no promises would be broken if an insider were to trade, and the moral calculus might lead to a different outcome.
Anderson comes to similar conclusions using a Kantian framework.
Crime and Punishment
Although Anderson finds most insider trading prohibitions morally justified, he is not convinced that some of the penalties currently being sought for insider trading are warranted: “Lying and deceiving can be harmful, but recall that we were unable to pin down a clear harm to either the counterparty or the market as whole…it would seem difficult to justify sentences in excess of twenty years that are now being sought by prosecutors.” Raj Rajaratnam was sentenced to 11 years in prison after prosecutors asked for sentencing of 19.5 to 24.5 years. Anderson finds it false to claim that insider trading is a wrong of the same magnitude as murder or rape.
The discontinuity between the magnitude of the crime and severity of the sentencing leads Anderson to speculate whether there is another dynamic behind the prosecutorial focus in insider trading. He cites a theory of cognitive dissonance first proposed by Kahan and Posner in 1999. They suggest a scenario where prosecution of insider trading is the reaction to a market crash: “No one knows whether the insider trading caused the crash, but some entrepreneur—maybe a government official—seizes the moment, blames the stock market crash on the insider trades, and starts prosecuting insider traders by exploiting some vague law.” Sound familiar?
The ongoing insider trading prosecutions are creating a series of consequences beyond increased compliance scrutiny. The ambiguity of U.S. insider trading law invites academic scrutiny and academics are rising to the challenge. Anderson’s paper provides some moral justification to existing insider trading law, but ultimately questions whether the current degree of prosecutorial diligence or the severity of the punishments are justified.